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Institutt for industriell økonomi og teknologiledelse [3034]

Masters Thesis: Valuation of Icelandair

Master thesis Valuation of Icelandair MSc in Economics and Business Administration Finance and Investments

Kári Gunnarsson

Supervisor: Professor dr.oecon Peter Ove Christensen Pages (excluding Appendix): 78 Characters (including spaces): 169.473

September 2016 2 Valuation of Icelandair

Master of Science Thesis

For the degree of Master of Science in Economics and Business Administration - Finance and Investment at Copenhagen Business School

Kari Gunnarsson

In this thesis the value of Icelandair is estimated and the stock price on April 8th 2016 is challenged. The valuation was performed using the Residual Operating Income (ReOI) model risk adjusted with the Adjusted Present Value (APV) method. The valuation relied on both a strategic and ﬁnancial analysis of Icelandair and the airline industry. The strategic analysis was carried out using the PESTEL, Porter’s Five Forces and VRIO models. The strategic analysis identiﬁed key value drivers for Icelandair, as well as determining potential risks and opportunities the company might face. The company’s ﬁnancial statements were reformulated to separate the value creating operations from the ﬁnancing part of business and then analyzed using a trend, common-size and proﬁtability analysis. The information from the analysis was used to forecast the value drivers in the ReOI model which were then risk adjusted using the APV method, forming the base case valuation. Additionally, two scenarios were valued using the same method to observe a broader value range for better and worse scenarios than presented by the base case. A sensitivity analysis was performed to test the calculated value per share result’s sensitivity to key inputs in the model. The base case valuation showed an estimated value of 26 to 29 ISK per share for Icelandair’s stock. This result suggest that the market is over valuing Icelandair’s equity by 30-40% on April 8th 2016. This result is backed up by a multiple analysis valuation indicating a signiﬁcant over valuation by the market. II Table of Contents

Acknowledgements xiii

1 Introduction 1 1.1 Motivation...... 1 1.2 Problem statement...... 1 1.3 Delimitation...... 2

2 Valuation Methodology3 2.1 The Residual Operating Income model...... 3 2.2 The Adjusted Present Value Model...... 5

3 Presentation of Icelandair and the Airline industry7 3.1 Icelandair Business Description...... 7 3.1.1 Route Network...... 8 3.1.2 Tourism Services...... 9 3.2 History...... 9 3.3 Ownership Structure and Share Information...... 10 3.4 Airline Industry...... 10

4 Peer Group 13 4.1 Air Berlin...... 13 4.2 Finnair...... 13 4.3 SAS...... 13 4.4 Norwegian Air Shuttle ASA...... 14

5 Strategic Analysis 15 5.1 PESTEL Analysis...... 15 5.1.1 Political & Legal issues...... 15 5.1.2 Economic issues...... 16 5.1.3 Sociocultural issues...... 21 5.1.4 Technological issues...... 22 5.1.5 Environmental...... 22 5.2 Porters Five Forces...... 23 5.2.1 Threat of new entrants...... 23 5.2.2 Bargaining power of buyers...... 24 5.2.3 Bargaining power of suppliers...... 25 5.2.4 Substituting products...... 25 5.2.5 Rivalry among existing ﬁrms...... 25 5.2.6 Summary of Porter’s 5 Forces...... 26 IV TABLE OF CONTENTS

5.3 Internal Analysis...... 26 5.3.1 VRIO Analysis...... 26 5.4 Industry Speciﬁc Analysis...... 28 5.4.1 Available Seat kilometer...... 29 5.4.2 Revenue Passenger kilometer...... 29 5.4.3 Load Factor...... 30 5.4.4 Yield per Passenger kilometer...... 31 5.4.5 Cost per Available Seat kilometer...... 31

6 Financial Analysis 33 6.1 Financial Statement Reformulation...... 33 6.1.1 Reformulation of the Statement of Shareholders’ Equity...... 33 6.1.2 Reformulation of the Balance Sheet...... 34 6.1.3 Reformulation of the Income Statement...... 35 6.2 Trend Analysis...... 35 6.3 Common Size Analysis...... 36 6.4 Proﬁtability Analysis...... 38 6.4.1 Proﬁt Margin...... 39 6.4.2 Asset Turnover...... 40 6.4.3 Return on Net Operating Assets...... 41 6.4.4 Financial Leverage & Operating Spread...... 41 6.4.5 Return on Common Equity...... 43

7 Quantitative Industry Analysis 45 7.1 Fade Diagrams...... 45 7.1.1 Methodology and data...... 45 7.1.2 Asset Turnover...... 47 7.1.3 Proﬁt Margin...... 47 7.1.4 Sales Growth...... 48 7.1.5 Net Operating Asset Growth...... 49 7.1.6 Return on Net Operating Assets...... 49 7.1.7 Market-to-book premium...... 50 7.2 Time-Series Analysis...... 51 7.2.1 Methodology...... 51 7.2.2 Autoregression estimates...... 51

8 Forecasting 55 8.1 Explicit Period (2016-2020)...... 55 8.1.1 Sales Growth...... 55 8.1.2 Proﬁt Margin...... 57 8.1.3 Asset Turnover...... 58 8.2 Fade Period...... 58 8.2.1 Sales Growth...... 59 8.2.2 Proﬁt Margin...... 59 8.2.3 Asset Turnover...... 59 TABLE OF CONTENTS V

9 Estimation of Icelandair’s Cost of Capital 61 9.1 Estimating the Term Structure of Interest Rates...... 61 9.1.1 Bond Pricing...... 61 9.2 Estimation of Icelandair’s Beta...... 64 9.2.1 Equity Beta...... 64 9.2.2 Bottom-up Beta...... 65 9.2.3 Icelandair’s Equity Beta...... 66 9.3 Equity Risk Premium...... 66 9.4 Cost of Capital...... 66

10 Valuation 69 10.1 Icelandair Base Case Valuation...... 69 10.2 Scenario Analysis...... 70 10.2.1 Optimistic Scenario Valuation...... 70 10.2.2 Pessimistic Scenario Valuation...... 71

11 Sensitivity Analysis 73

12 Multiple Valuation 77

13 Conclusions 79

References 83

Glossary 87 List of Acronyms...... 87 List of Symbols...... 88 Appendix A...... 89 Appendix B...... 91 Appendix C...... 95 Appendix D...... 99 Appendix E...... 101 Appendix F...... 103 VI TABLE OF CONTENTS List of Figures

3-1 Number of Icelandair’s international rout passengers per month for 2014 & 2015. Own creation, data from (Icelandair Group hf, n.d.-f)...... 7 3-2 Split of business segments measured by revenues in 2015. Own creation, data from (Icelandair Group hf, 2016b)...... 8 3-3 Icelandair’s distribution of ownership, yearend 2015(Bloomberg, n.d.-e).... 10 3-4 Development in share price since January 2011 (Bloomberg, n.d.-f)...... 10 3-5 Airline passengers worldwide from 1973-2014. Own creation, data from (The World Bank, 2015)...... 11 3-6 Annual net proﬁts in millions of US dollars for world airlines, 1974 - 2015. Own creation, data from (International Civil Aviation Organization, n.d.)...... 12

5-1 World GDP and Passengers carried globally, showing percentage change. Own creation, data from (The World Bank, 2015; International Monetary Fund, 2016). 17 5-2 Nominal World GDP and Passengers carried worldwide, Data normalized to show correlation. Own creation, data from (The World Bank, 2015; Interna- tional Monetary Fund, 2016)...... 17 5-3 International visitors to Iceland , from 2009 to 2014. Own creation, data from (Ferdamalastofnun, 2015)...... 18 5-4 Jet fuel per gallon monthly prices in US dollars. Own creation, data from (Indexmundi, n.d.)...... 19 5-5 Jet fuel and Crude Oil prices per barrel, monthly prices in US dollars. Own creation, data from (Indexmundi, n.d.)...... 19 5-6 Average annual price (USD) of crude oil in nominal values not adjusted for inﬂation. Own creation, data from (Inﬂationdata, n.d.)...... 20 5-7 Porter’s Five Forces. Own creation, data from (Porter, 1980)...... 24 5-8 VRIO analysis process. Own creation, data from (Rothaermel, 2012)..... 27 5-9 Available seat km for Icelandair and the peer group in millions. Own creation, data from (Bloomberg, n.d.-a)...... 29 5-10 Revenue Passenger km for Icelandair and the peer group in millions. Own creation, data from (Bloomberg, n.d.-a)...... 30 5-11 Load Factor for Icelandair and the peer group. Own creation, data from (Bloomberg, n.d.-a)...... 30 5-12 Yield per Passenger km for Icelandair and the peer group in millions. Own creation, data from (Bloomberg, n.d.-a)...... 31 5-13 Total Cost Per Available Seat km for Icelandair and the peer group. Own creation, data from (Bloomberg, n.d.-a)...... 32

6-1 Core Proﬁt Margin for Icelandair and the average core PM from the selected peer group. Own creation, data from (COMPUSTAT, n.d.)...... 39 6-2 Asset Turnover of Icelandair and the average for the selected peer group. Own creation, data from (COMPUSTAT, n.d.)...... 40 VIII LIST OF FIGURES

6-3 RNOA for Icelandair & the average for the selected peer group. Own creation, data from (COMPUSTAT, n.d.)...... 41 6-4 Financial Leverage of Icelandair & the average for the selected peer group. Own creation, data from (COMPUSTAT, n.d.)...... 42 6-5 Operating Spread (RNOA-NBC) for Icelandair & the average for the selected peer group. Own creation, data from (COMPUSTAT, n.d.)...... 42 6-6 Return on Common Equity for Icelandair & the average from the selected peer group. Own creation, data from (COMPUSTAT, n.d.)...... 43

7-1 Fade Diagram, Asset Turnover for the Airline industry. Own creation, data from (COMPUSTAT, n.d.)...... 47 7-2 Fade Diagram, Proﬁt Margin for the Airline industry. Own Creation, data from (COMPUSTAT, n.d.)...... 48 7-3 Fade Diagram, Sales Growth for the Airline industry. Own creation, data from (COMPUSTAT, n.d.)...... 48 7-4 Fade Diagram, Net Operating Asset Growth for the Airline industry. Own creation, data from (COMPUSTAT, n.d.)...... 49 7-5 Fade Diagram, Return on Net Operating Asset Growth for the Airline industry. Own Creation, data from (COMPUSTAT, n.d.)...... 50 7-6 Fade Diagram, Market-to-book ratio for the Airline industry. Own creation, data from (COMPUSTAT, n.d.; Bloomberg, n.d.-d)...... 50

8-1 Passenger Revenue and growth from 2011 to 2015. Own creation, data from Icelandair’s Annual Reports...... 55 8-2 GDP Normalized data. Own creation, data from (The World Bank, 2015).. 56 8-3 Passengers carried and growth. 2016 estimated by Icelandair. Own creation, data from Icelandair’s Annual Reports...... 57 8-4 Forecast period for the ReOI value drivers: PM, SG and ATO...... 58

9-1 Nelson & Siegel model prices ﬁtted to market prices. Own creation, Market price from (Sedlabanki Islands, n.d.)...... 63 9-2 Risk free zero coupon yield curve and forward rates, discretely compounded.. 63 9-3 Term structure of Icelandair’s cost of capital...... 67

11-1 Share value sensitivity to 30% change in inputs - Gordon’s Growth formula.. 73 11-2 Share value sensitivity to 30% change in inputs - NOA/EV Multiple...... 74

13-1 Summary of Icelandair’s valuation...... 82

2 Icelandair’s international route network (Icelandair Group hf, n.d.-e)..... 89 3 Market segmentation for world air travel in 2014. Own creation, data from (MarketLine, 2015)...... 90 4 Geography segmentation of world air travel in 2014. Own creation, data from (MarketLine, 2015)...... 90 5 Reformulation of Icelandair’s Equity Statement. Adopted from Icelandair’s Annual Reports...... 91 LIST OF FIGURES IX

6 Ratio analysis of Icelandair’s Equity Statement. Adopted from Icelandair’s Annual Reports...... 91 7 Reformulation of Icelandair’s Income Statement. Adopted from Icelandair’s Annual Reports...... 92 8 Reformulation of Icelandair’s Balance Sheet. Adopted from Icelandair’s Annual Reports...... 93 9 Common size analysis for selected income statement items, peer group com- parison. Own creation, data from companies Annual Reports...... 94 10 Long-run levels and persistency for ATO. Own creation, data from (COMPUSTAT, n.d.)...... 95 11 Long-run levels and persistency for PM. Own creation, data from (COMPUSTAT, n.d.)...... 96 12 Long-run levels and persistency for sales growth. Own creation, data from (COMPUSTAT, n.d.)...... 96 13 Long-run levels and persistency for NOA growth. Own creation, data from (COMPUSTAT, n.d.)...... 97 14 Long-run levels and persistency for RNOA. Own creation, data from (COMPUSTAT, n.d.)...... 97 15 Long-run levels and persistency for EV/NOA growth. Own creation, data from (COMPUSTAT, n.d.)...... 98 16 Nelson-Siegal pricing errors...... 99 17 Forecast period for ReOI value drivers. Optimistic scenario...... 101 18 Forecast period for ReOI value drivers. Pessimistic scenario...... 101 19 Share value sensitivity to 30% change in inputs - Gordon’s Growth formula.. 103 20 Share value sensitivity to 30% change in inputs - NOA/EV Multiple...... 103 21 Value per share change - ERP...... 107 22 Value per share changes - Terminal growth and long-term EV/NOA...... 107 X LIST OF FIGURES List of Tables

4-1 Summary of the peer group overview. Own creation, data from companies Annual Letters...... 14

5-1 Summary of Porter’s Five Forces...... 26 5-2 Summary of VRIO analysis...... 28

6-1 Trend Analysis for the Income Statement. Own creation, data from Icelandair’s Annual Reports...... 36 6-2 Trend Analysis of selected Balance Sheet items. Own creation, data from Icelandair’s Annual Reports...... 36 6-3 Common Size Analysis for Icelandair, selected items from the Income state- ment. Own creation, data from Icelandair’s Annual Reports...... 37 6-4 Common size analysis for selected income statement items, peer group com- parison. Own creation, data from companies Annual Reports...... 37

7-1 Autoregression estimates on value drivers and EV/NOA. Own creation, data from (COMPUSTAT, n.d.; Bloomberg, n.d.-d)...... 52

9-1 Nelson-Siegel model parameter estimation...... 63 9-2 Beta estimation using ﬁve year weekly returns. Own creation, data from (Datastream, n.d.)...... 64 9-3 Damodaran Air Transport beta estimation - average values. Own creation, adopted from (Damodaran, n.d.-b, n.d.-a)...... 65

10-1 Base case value driver forecast assumptions...... 69 10-2 Summary of Icelandair’s Base case valuation...... 70 10-3 Summary of Icelandair’s Optimistic scenario valuation...... 71 10-4 Summary of Icelandair’s Pessimistic scenario valuation...... 72

11-1 Sensitivity analysis for Proﬁt Margin - Gordon’s Growth formula...... 74 11-2 Sensitivity analysis for Proﬁt Margin - EV/NOA method...... 75 11-3 Sensitivity of valuation to ERP estimation- Long-term Sales Growth 5%.... 76 11-4 Sensitivity of valuation to ERP estimation - Long-term Sales Growth 2,5%.. 76

12-1 Multiple valuation - peer group multiples. Own creation, data from (Bloomberg, n.d.-c)...... 77 12-2 Icelandair Value per share based on multiple valuation...... 77

1 Icelandair top shareholders at yearend 2015. Adopted from (Icelandair Group hf, 2016b)...... 89 2 Equity beta linear regression...... 100 XII LIST OF TABLES

3 Sensitivity analysis for Asset Turnover - Gordon’s Growth formula...... 104 4 Sensitivity analysis for Asset Turnover - EV/NOA method...... 104 5 Sensitivity analysis for Sales Growth - Gordon’s Growth formula...... 104 6 Sensitivity analysis for Sales Growth - EV/NOA method...... 105 7 Sensitivity analysis - Target Capital Structure...... 105 8 Sensitivity analysis - Firm Beta...... 106 Acknowledgements

I would like to thank my supervisor prof.dr.oecon. Peter Ove Christensen for his imperative assistance during the writing of this thesis. Also special thanks go to my dad Gunnar Her- bertsson, my mom Sigrun Einarsdottir and my lovely Aureja Zelvyte - Takk fyrir allt.

Copenhagen Business School Kari Gunnarsson 15.9.2016 XIV ACKNOWLEDGEMENTS 1| Introduction

1.1 Motivation

Valuation is the process of determining the worth of a security. For this thesis I have chosen to value the most exciting security (to me) there is: Equity. Equity is the diﬀerence between the value of assets and the cost of liabilities values and represents the owners’ claim to a company. Valuing companies is an interesting and challenging task as businesses do not have contractual payments like bonds and therefore pinpointing the value of equities representing pieces of a business can be hard to do (Klarman, 1991). Investing in equities or buying stocks, means to buy a portion of a business. The price is set by the market, or the owners of the stock and those looking to buy the stock. The excitement comes from ﬁnding companies whose value diﬀers from the price quoted by the market. Benjamin Graham(1949) described equity investing as a negotiation with a manic-depressive character called “Mr. Market” over the price of securities. Mr. Market is an analogy for the irrationality of the stock market and describes how investors should look to take advantage of the discrepancy between the intrinsic value of a security and the market price when the market is pricing securities to depressively or optimistically. Inherent in all markets is that there exist diﬀerences of opinions regarding the value of the traded good, how intrinsic the asset value is, depends on the market. Unlike a piece of painting or sculpture, a company’s value can be determined from its future earning potential and not simply what other investors might be willing to pay for it later. The process of a valuation can be described as being somewhere between art and science as there are many uncertainties involved in estimating a company’s intrinsic value. The act of valuing a company is a challenge towards the notion that markets are eﬃcient and that prices reﬂect values. Using a fundamental analysis to challenge the idea of an eﬃcient market however rests on the assumption that market prices will revert to fundamental values in the long-run. The purpose of this thesis is to analyze and value Icelandair, a long standing airline operating out of Iceland. Icelandair is an interesting company in an interesting market situation. Since the economic collapse in 2008, Iceland has been under capital controls. The capital controls restrict Icelandic investors to Icelandic capital markets and for the longest have heavily limited foreign investors activity. From the collapse, Icelandair cleaned up its operations, so to focus on the air transportation and hotel business, and has since soared. These recent events and the potential lift of the capital controls make Icelandair an exciting proposition for a valuation. The valuation is performed using a fundamental analysis approach, using a method described in Chapter2 to estimate the intrinsic value of Icelandair. The valuation date is set after the market closes on April 8th 2016 and at the date of the valuation, Icelandair’s share price is at an all-time high of 37,3 ISK. The thesis sets out to investigate whether this price is justiﬁed or if Mr. Market is oﬀ.

1.2 Problem statement

"What is the Intrinsic value per share of Icelandair on April 8th 2016?" The thesis sets out to answer the question using a fundamental analysis valuation approach. The intrinsic value will be estimated using the Residual Operating Income (ReOI) model. 2 INTRODUCTION

In order to be able to implement the model and answer the research question above, the following sub-questions are investigated and answered.

• What is Icelandair’s business and what operations generate most of its earnings?

• What characteristics deﬁne the industry it operates in?

• What macro-economic factors aﬀect Icelandair and its future earnigs potential?

• How does the competitive environment look like for Icelandair?

• What are Icelandair’s internal resources and competencies?

• How are Icelandair’s ﬁnancials split into operating and ﬁnancing? And what trends are visible from historical accounting numbers?

• How has Icelandair’s proﬁtability evolved compared to its peers in recent history?

• What are Icelandair’s key value drivers and how have these value drivers evolved for the industry?

• How is Icelandair expected to perform in the near-future? And how will the value drivers fade in the long-term?

• What is the estimated cost of capital for Icelandair?

These sub-question form a general guideline throughout the thesis and are important steps when doing fundamental analysis to estimate the intrinsic value of Icelandair. They further emphasis that the valuation is based on quantitative values.

1.3 Delimitation

In order to maintain the scope of the thesis and to keep emphasis on key factors to estimate the intrinsic value of Icelandair and therefore answering the research question, it is constrained by several delimitations. The valuation date is after market closing on April 8th 2016 and no information after that date is considered in the analysis. The valuation is conducted from a public investor’s perspective and therefore this report is solely based on publicly available information and data. All information is secondary information, either through information publicly provided by the company, it’s annual reports or ﬁnancial databases and no contact has been made to the company. The strategic analysis will focus on Icelandair’s main operations, the air transportation of passengers. This limitation, serves to keep the scope of the paper in line as it is signiﬁcantly the largest of Icelandair’s operations. It further ensures consistency when comparisons to peers are made. There are many methods available to estimate the intrinsic or fair value of equity, this thesis is based on the ReOI valuation method, described in Chapter2, and with a valuation based on multiples as accessory. 2| Valuation Methodology

This chapter will present and describe the valuation methodology implemented in the thesis. There are many valuation methods available to investors and researchers, each with their strengths and weaknesses. For this thesis the primary valuation is performed using the Resid- ual Operating Income (ReOI) model, risk adjusted with the Adjusted Present Value (APV) method. A secondary valuation is also performed using a multiples. Both the ReOI and APV methods will be described in the following sections.

2.1 The Residual Operating Income model

The Residual Operating Income model is an earnings based valuation model that is built upon the Residual Earnings (RE) model. TheRE model is a model that measures the value added from future residual earnings, and shows present value of equity as current book value plus the present value of forecasted residual earnings. Residual earnings are comprehensive earnings less the required return for equity times the beginning-of-period book value. Equity value is thus calculated as (Penman, 2013):

E E RE1 RE2 RE3 RET VT − BT V0 = + 2 + 3 + ··· + T + T , ρE ρE ρE ρE ρE where REt are the expected residual earnings for equity in each period t to T and calculated as: REt = Earnt − (ρE − 1) CSEt−1

Earnt represents the comprehensive earnings for period t, ρE is the required return for equity and CSEt−1 is the book value of common shareholders’ equity at the beginning of the period. Residual earnings represent return on common equity, but expressed as a dollar excess return. Residual earnings can be broken down into two components that drive its value, Return On Common Equity (ROCE) and book value. Residual earnings are therefore driven by the investment of shareholders and the rate of return on this investment relative to the cost of capital. The rate of ROCE is calculated as the ratio between earnings and common shareholders’ equity (Penman, 2013):

Earnt ROCEt = CSEt−1 Therefore, the residual earnings can be restated as:

REt = [ROCEt − (ρE − 1)] CSEt−1

Residual earnings therefore compare ROCE to (ρE −1) and expresses the diﬀerence as a dollar amount by multiplying it with the beginning-of-period book value of equity. This shows that an asset that is expected to earn a return on common equity equal to the required return, that is ROCE = (ρE − 1), will not produce any residual earnings. Therefore, only activities that are expected to earn a return above the required return will have positive residual earnings and should be at a premium to its book value. Assets that are measured at market value in the 4 VALUATION METHODOLOGY balance sheet will therefore not need to be forecasted as they will earn at their required rate of return and not produce residual earnings. Assuming that all ﬁnancial assets are measured at or close to market value in the balance sheet, all residual earnings are thus assumed to stem from operating assets. This leads us to the residual operating income model, as ReOI is residual earnings from net operating assets and calculated as (Penman, 2013):

ReOIt = OIt − (ρF − 1) NOAt−1 ,

where OIt is operating income for period t and NOAt−1 is net operating assets at beginning- of-period t. Residual operating income can be expressed as the excess return on operations in dollar amount. As with theRE model, the ReOI model can be broken down into two drivers, Return on Net Operating Assets (RNOA) and the book value of Net Operating Assets (NOA) that are put in place to earn the RNOA.

ReOIt = [RNOAt − (ρF − 1)] NOAt−1 , where RNOAt and NOAt−1 are calculated as:

RNOAt = PMt × AT Ot , Salest NOAt−1 = , AT Ot where PM is the Proﬁt Margin and ATO represents Asset Turnover. ReOI is therefore driven by the NOA that are put in place and the proﬁtability of those assets relative to the cost of capital. Value is then added to the book value by earning a greater RNOA than the cost of capital. As RNOA and NOA have a common driver ATO, ReOI can therefore also be determined as (Nissim & Penman, 2001): ρE − 1 ReOIt = Salest PMt − AT Ot The present value of equity is calculated as:

E NOA NFO V0 = V0 − V0

As discussed above, the expected residual net ﬁnancial expenses will be zero and therefore the value of equity can be calculated using the ReOI model as:

F E ReOI1 ReOI2 ReOI3 ReOIT CV T V0 = CSE0 + + 2 + 3 + ··· + T + T , ρF ρF ρF ρF ρF

F where CV T denotes the Continuing Value (CV) for the ﬁrm. TheCV is calculated using two methods, using Gordon’s growth formula with a constant growth rate and a market-to-book premium. Using the Gordons growth formula theCV is calculated as:

F ReOIT +1 CV T = , ρF − g where g is the constant growth rate. 2.2 THE ADJUSTED PRESENT VALUE MODEL 5

TheCV is also calculated using the market-to-book premium. Instead of using a forecasted growth rate to inﬁnity, the market-to-book premium is forecasted. Using the market-to-book premium theCV is calculated as (Christensen, 2015b):

F ! F VT CV T = − 1 NOAT , NOAT

F where VT is the Enterprise Value (EV) of the ﬁrm.

2.2 The Adjusted Present Value Model

There are generally two methods used for risk adjusting purposes in valuation, these are the Weighted Average Cost of Capital (WACC) method or the Adjusted Present Value (APV) method. The methods are similar in many ways and both adjust for risk in the denominator. The APV method calculates the Net Present Value (NPV) of all equity ﬁnanced projects and then adds the value of tax and other beneﬁts of debt to it, while the WACC method accounts for the beneﬁts of debt by adjusting the discount rate (Hillier, Grinblatt, & Titman, 2012). Both methods will yield identical results under idealized conditions, the APV method is how- ever preferred due to its ﬂexibility. The APV method is also superior as it is consistent with the distinction between value creating operating activities and zero-NPV ﬁnancing activities. The APV method considers the tax shield a value creating activity and thus eliminates the need to re-allocate taxes between operating and ﬁnancing activities, as all taxes are assumed part of operations (Christensen & Feltham, 2009). In the APV method a ﬁrm’s value is determined as the sum of debt and equity and of the comprehensive operating assets. Equity value can therefore be expressed as (Christensen & Feltham, 2009): Vτ = (UAτ + TSτ + BCτ + ... ) − Dτ , where UAτ is the unlevered value of the ﬁrm at any future date τ,TS τ is the value of the future tax shield, BCτ is the value of future bankruptcy costs and Dτ is the value of debt. This shows another advantage of the APV method, as it follows the value additivity principle so that the value of the ﬁrm is the sum of the values of its diﬀerent components (Christensen & Feltham, 2009).

For this thesis the bankruptcy costs are assumed to be zero (BCτ = 0) and the assumption that the amount of future debt is continuously adjusted in order to keep the tax shield proportional to the free cash ﬂows from operations (Christensen & Feltham, 2009; Miles & Ezzell, 1980). Therefore, allTS value is included in the expected ReOI and the value of the ﬁrm can once again be stated as:

F E ReOI1 ReOI2 ReOI3 ReOIT CV T V0 = CSE0 + F + F + F + ··· + F + F , Rtτ1 Rtτ2 Rtτ3 Rtτ Rtτ

F where ReOIτ now includes the value of the TSτ and Rtτ is 1 plus the required rate of return for the ﬁrm. Assuming a constant risk premium the required rate of return can be expressed as (Christensen, 2015c; Brennan & Xia, 2003):

F Rtτ = (1 + ιtτ ) (1 + RP F ) , 6 VALUATION METHODOLOGY

where ιtτ is the discretely compounded zero-coupon rate at time t with maturity at τ and RPF the constant risk premium for the ﬁrm. This will be explained in more detail in Chapter9 where the cost of capital is estimated. 3| Presentation of Icelandair and the Airline industry

3.1 Icelandair Business Description

Icelandair Group is an Icelandic holding company based out of Iceland and operates within the international airline and tourism sector. Icelandair Group is listed on the Icelandic stock exchange, Nasdaq OMX Iceland, under the symbol ICEAIR. Icelandair Group (hereafter Icelandair or the company) is the parent company of nine sub- sidiaries covering two business segments: route network and tourism services. The route network segment is the larger and more important of the two, comprising elements such as scheduled airlines, cargo and ground services. The tourism services play a supporting role pro- viding value added services such as hotels and travel agencies. Icelandair’s business concept is centered around Iceland’s unique geographical location, between Europe and North Amer- ica in the middle of the ﬂight routes between the two continents, making it an ideal central point for an international hub-and-spoke network (Icelandair Group hf, 2015). Icelandair’s ﬂeet consists of a total of 43 aircrafts, of which 35 are owned by the company. In 2015 Ice- landair carried 3.4 million passengers on its international and regional routes, increasing their total number of passengers on the international rout by nearly 18% from the previous year, while still increasing their load factor1 at the same time, see Figure 3-1(Icelandair Group hf, 2016b).

450.000 2015 2014 400.000

Number of passengersNumber of

Figure 3-1: Number of Icelandair’s international rout passengers per month for 2014 & 2015. Own creation, data from (Icelandair Group hf, n.d.-f).

1Load factor is a measure of utilization of capacity. Measures how eﬃciently airlines ﬁll seats, see Section 5.4.3. 8 PRESENTATION OF ICELANDAIR AND THE AIRLINE INDUSTRY

3.1.1 Route Network

The route network is Icelandair’s cornerstone, bringing in close to 90% of the revenues in 2015 (see Figure 3-2). Through its route network Icelandair oﬀers air transportation to 39 destinations, 25 European cities and 14 North American cities. The route network is operated through 7 of the company’s subsidiaries: Icelandair, Icelandair Cargo, Loftleidir Icelandic, Air Iceland, Icelandair Ground Services, Feria and Fjarvakur (Icelandair Group hf, 2016a).

Route network

Tourism services

10,4% 89,6%

Figure 3-2: Split of business segments measured by revenues in 2015. Own creation, data from (Icelandair Group hf, 2016b).

Icelandair splits its route network into three diﬀerent and independent passenger markets: FROM, TO and VIA. The FROM market serves the Icelandic domestic market, which mainly consists of Icelanders traveling abroad. The TO market serves tourists with Iceland as their ﬁnal destination. And the VIA market, serving the international market traveling between Europe and North America. The VIA market is the largest of the three and has been the main driving force of growth in the Rout Network, in 2015 it accounted for 49% of the total number of passengers (Icelandair Group hf, 2016b).

Icelandair is able to take advantage of Iceland’s advantageous geographical positioning by serving these three markets with the same aircrafts using the hub-and-spoke network with Iceland as the hub. Flights from Iceland to Europe take between 3 and 4 hours, and ﬂights to North America are 5 to 8 hours long, enabling the use of a narrow-body Boeing 757 aircraft for the entire route network (Icelandair Group hf, 2015). This allows Icelandair to be eﬃcient, by oﬀering higher ﬂight frequency and a greater variety of destinations while at the same time keeping costs low. Icelandair currently has 25 Boeing 757 passenger planes in its ﬂeet, each with a seating capacity of 183 passengers (Icelandair Group hf, n.d.-b) and in 2016 the company is adding two 767-300 wide body aircrafts seating 262 passengers to its ﬂeet. The new 767’s will be a good addition to the ﬂeet as the have a higher seating capacity that will facilitate routes with a high passenger load factor with limited airport slot availability. The new aircrafts also have a greater range that will allow Icelandair to open up new market opportunities (Icelandair Group hf, 2016b). Icelandair’s Rout Network is shown visually in Figure2 in Appendix A. 3.2 HISTORY 9

3.1.2 Tourism Services

The tourism service segment is focused on catering the growing demand for tourist services in Iceland. The segment oﬀers a wide range of tourism value adding services, it comprises: hotels, domestic tour packages and travel agencies. Icelandair’s tourism services mainly operate through two of the subsidiaries: Iceland Travel and Icelandair Hotels (Icelandair Group hf, 2015). Icelandair Hotels is the group’s hotel chain, oﬀering hospitality services through a mix of international and local brands. The company runs Hilton Reykjavik Nordica, Icelandair Hotel Reykjavik Natura and Icelandair Hotel Reykjavik Marina in Reykjavik as well as 18 smaller hotels around the country side and in smaller towns in Iceland. The vision of the hotel operations is to create an authentic Icelandic experience for tourists (Icelandair Group hf, n.d.-d). Iceland Travel is the company’s tour operator and destination manager. It is the largest tourism service provider in Iceland, oﬀering a wide range of services for travelers, including leisure, MICE (Meetings, Incentives, Conferences and Events) and cruise services (Icelandair Group hf, n.d.-d).

3.2 History

Icelandair’s roots can be traced back to the founding of the ﬁrst Icelandic airline Flugfelag Akureyrar on the north coast of Iceland in 1937. In 1943 the company moved its headquarters to Reykjavik and changed its name to Flugfelag Islands, which later assumed the international trade name Icelandair. Another important milestone in Icelandair’s history is the founding of Loftleidir in 1944, which later became known as Icelandic Airlines (Icelandair Group hf, n.d.-c). In 1945 Flugfelag Islands began its international operations with ﬂights from Iceland to Scotland and Denmark. Loftleidir followed and began its international operation in 1947 (Icelandair Group hf, n.d.-c). Flugfelag Islands and Loftleidir merged under a new holding company Flugleidir in 1973. In 1979 Flugleidir took up the international trade name Icelandair, but retained the Flugleidir name in the Icelandic domestic market (Icelandair Group hf, n.d.-c). In 1987, on the company’s 50th anniversary, Icelandair signed a major contract agreement with Boeing to renew the ﬂeet serving international ﬂights. A new generation of Boeing jets (757-200 and 737-400) replaced the older ﬂeet gradually from 1989 to 1993, before a single type ﬂeet of 757 was established in 2003 (Icelandair Group hf, n.d.-c). Icelandair Group became a publicly listed company in December 2006, when the company was listed on the Icelandic Stock Exchange (ICEX) under the symbol ICEAIR. Following the collapse of 2008, in 2009 Icelandair Group started a ﬁnancial restructuring. This consisted of debt restructuring through a mix of debt-to-equity conversions and extensions of loan maturities. The group further divested on most non-core assets and issued additional new equity of 4 billion ISK. In February 2011 the company announced that the ﬁnancial restructuring was complete and has since been growing its core business at a good pace. In 2015 passengers in the international rout network amounted to over 3 million, increasing by roughly 107% from 2010 (Icelandair Group hf, n.d.-c). 10 PRESENTATION OF ICELANDAIR AND THE AIRLINE INDUSTRY

3.3 Ownership Structure and Share Information

Total number of shares at the end 4,76% 0,38% Pension Fund of year 2015 was 5 billion of which the company held treasury shares Other 20,42% of around 25 million leaving 4,975 Investment Advisor billion shares outstanding. The Bank number of shareholders at the end of year 2015 was 2.386. Figure 3- Individual 3 shows the ownership structure at year end 2015. Icelandic pen- 48,56% sion funds own close to 50% of all 25,88% outstanding shares and the top 10 owners hold over 60% of Icelandair shares (see Appendix A). This is Figure 3-3: Icelandair’s distribution of ownership, yearend not uncommon in Iceland where lo- 2015(Bloomberg, n.d.-e). cal pension funds are majority own- ers in most listed companies. The day of valuation is the 8th of April 2016, when closing price was 37,3 ISK per share. Icelandair’s historical share price and volume for the past 5 years are shown in Figure 3-4.

40 600.000.000 Volume Share price 35 500.000.000

400.000.000

25 Trading Volume

20 300.000.000

15 Share Price (ISK) SharePrice 200.000.000

100.000.000 5

0 - 24.1.2011 24.1.2012 24.1.2013 24.1.2014 24.1.2015 24.1.2016

Figure 3-4: Development in share price since January 2011 (Bloomberg, n.d.-f).

3.4 Airline Industry

Few inventions have had as much impact on the world as the invention of the airplane. The introduction of jet engine aircrafts for commercial use in the 1950s and the development of the “jumbo-jets” in the 1970s had enormous eﬀect on the global airline industry. But at that time the airline industry was heavily regulated around the globe. This regulation created 3.4 AIRLINE INDUSTRY 11 an environment that catered to technical innovation but left out any need for Airlines to be competitive and focus on proﬁtability. This was not good for the general public and meant that air travel was expensive and only for the wealthy (by western standards) who could aﬀord the high prices charged by airlines. It wasn’t until the deregulation of the airline industry, starting in 1978 in the USA, that airlines started to focus on cost eﬃciency and being proﬁtable (Belobaba, P. , Odoni, A. R. and Barnhart, C., 2009). This has completely changed the whole industry and had great eﬀect on the world as a whole. Air travel is no longer only for the selected few but instead an integrated part of society, it is now aﬀordable for most (in the western part of the world) to travel by plane both domestically and internationally. It has changed how people think about distance and it has made it possible to conduct business and visit places that were out of reach before.

llions) 2000

Passengers (mi Passengers 1000

Figure 3-5: Airline passengers worldwide from 1973-2014. Own creation, data from (The World Bank, 2015).

In year end 2014 the global airline industry was valued at $585.277 million, an increase of $148.585 million since 2010 or a CAGR2 of 7,6% (MarketLine, 2015). As we can see from Figure 3-5 the industry’s passenger volume has increased rapidly and with only minor declines for short periods since the 1970s, in 2014 over 3 billion passengers were carried by airlines worldwide (The World Bank, 2015). The market can be separated into two segments: domestic and international. In terms of passengers carried the segments are roughly 60/40 with the domestic market the larger of the two. In terms of geography the value of the airline industry is mainly split among the Americas, Asia-Paciﬁc and Europe (MarketLine, 2015). Figure4 in Appendix A shows the global airlines industry geography segmentation at year end 2014.

2Compounded Annual Growth Rate 12 PRESENTATION OF ICELANDAIR AND THE AIRLINE INDUSTRY

With all this growth in the global airline industry, most airlines are still ﬁnding it hard to be proﬁtable and competition is tough. Proﬁt margins are thin and the industry is charac- teristically unstable and highly cyclical. As shown in Figure 3-6 the total net proﬁts of all airlines of the member states of the International Civil Aviation Organization (ICAO) have been very cyclical over the past four decades.

illions) 10000

Net profits, (m USDprofits, Net

Figure 3-6: Annual net proﬁts in millions of US dollars for world airlines, 1974 - 2015. Own creation, data from (International Civil Aviation Organization, n.d.).

The airline industry’s cycles appear to be closely tied to the world economic climate, when the world economy slows down; demand for air travel seems to follow (Doganis, 2006). Airlines are also vulnerable to a host of outside factors such as wars, terrorism, natural disasters and infectious diseases to name a few. And with jet fuel as a major cost, swings in oil prices can have major impacts on the proﬁtability of airlines. There are many factors that aﬀect the airline industry and those will be discussed in further detail in the Strategic Analysis in Chapter5. Even with this strong cyclical trend in the industry there have been airlines that consistently show proﬁt even during downturns and likewise there have also been those who are unable to proﬁt when the industry as a whole has operated proﬁtably. As a whole the industry is marginal, even though individual airlines have been able to be proﬁtable the industry has not been very proﬁtable compared to other sectors in general (Doganis, 2006). 4| Peer Group

In this chapter the selected peer group is presented. The peer group serves as a reference that Icelandair will be measured against in the next chapters. It is important that the companies selected in the peer group are in the same industry, operate in similar markets and are somewhat similar in size to Icelandair. The peer group has been selected based on the following criteria being similar to Icelandair: ﬂeet size, average number of employees and passengers carried. The group was further narrowed down by accounting standards and ownership. The companies selected in the ﬁnal peer group are well known airlines, most of whom are larger in size than Icelandair, but follows the same accounting standards and are publicly listed on a stock exchange. The peer group selected for this analysis consists of: SAS, Norwegian, Finnair, and Air Berlin. None of these companies are exactly alike; they follow diﬀerent business models and strategies, and don’t operate in the exact same geographical markets. The following sections give a brief introduction of each company in the peer group and Table 4-1 shows the summary of statistics for each company in the peer group

4.1 Air Berlin

Airberlin is a full service international airline operating out of Berlin, Germany. Airberlin’s core markets are Germany along with Austria and Switzerland. The company is listed on the Frankfurt Stock Exchange under the symbol AB1. Airberlin is one of Europe’s leading airlines and the 8th largest in terms of passengers carried. With a ﬂeet of 153 aircrafts and 8.869 employees the company carried 30,25 million passengers to 138 destinations in 2015 (Airberlin Group, 2016). Airberlin’s main hubs are in Berlin and Dusseldorf, from where it oﬀers intercontinental ﬂights both to North America and Asia (Airberlin Group, n.d.).

4.2 Finnair

Finnair is Finland’s national carrier operating out of Helsinki, Finland, where its main base is also located. Finnair is listed on the NASDAQ OMX Helsinki stock exchange. The Finnish government is the major shareholder holding 55,8% of outstanding shares. Much like Ice- landair, Finnair looks to take advantage of the competitive advantage provided by the geo- graphical location of its hub in Helsinki. Some of the fastest routes between many destinations in Europe and Asia go through Helsinki. This allows Finnair to connect the northern regions of Europe to Asia and North America through its hub at Helsinki (Finnair Group, n.d.). In 2015 Finnair carried 10,3 million passengers, a record in the company’s history. Finnair operates 46 aircrafts in its ﬂeet, thereof 23 are owned by the company, oﬀering 70 destinations in its route network and employed on average 4.906 people in 2015 (Finnair Group, 2016).

Scandinavian Airlines System or SAS is the national airline of Denmark, Norway and Sweden, operating primary hubs in all three countries. SAS is the largest airline in the Nordic region and the company is listed on the Stock Exchanges in Stockholm, Copenhagen and Oslo. SAS 14 PEER GROUP priority is on business travelers and has corporate contracts with many companies in the Nordics. In 2015 SAS carried 26,9 million passengers with a ﬂeet consisting of 152 aircrafts and a staﬀ of 11.288 employees. The company oﬀers 119 destinations all over Europe, North America and Asia (SAS AB, 2016).

4.4 Norwegian Air Shuttle ASA

Norwegian Air Shuttle or Norwegian is a low cost airline based out of Oslo, Norway. The company’s shares are listed on the Oslo Stock Exchange. Norwegian’s route network spans across Europe as well as into North Africa, the Middle East, North America, The Caribbean and Southeast Asia. At year end 2015 Norwegian’s ﬂeet of 99 aircrafts operated 447 routes to 138 destinations with an average number of 4.576 employees. Norwegian’s mission is to oﬀer quality service at a low fare (Norwegian Air Shuttle ASA, 2016).

Table 4-1: Summary of the peer group overview. Own creation, data from companies Annual Letters.

Fleet Employees Passengers Destinations Load factor (million) (%) Icelandair 43 3.384 3,40 39 83,10 Airberlin 153 8.869 30,25 138 84,18 Finnair 46 4.906 10,30 70 80,40 SAS 152 11.288 26,90 119 74,46 Norwegian 99 4.576 25,80 138 86,20 5| Strategic Analysis

In this chapter a strategic analysis of Icelandair and its environment is conducted. The strategic analysis should give a better picture of Icelandair’s macro- and micro environment and what kind of challenges and/or opportunities the company faces. This kind of analysis is important as it serves as a foundation for forecast of future outlook for the company and it reveals important factors that cannot be identiﬁed through the analysis of the company’s ﬁnancials alone. For Icelandair, the strategic analysis has been split into three chapters, each looking at the company and its environment from a diﬀerent point of view. The macro environment is ana- lyzed in Section 5.1 using a PESTEL framework, in Section 5.2 Icelandair’s micro economic factors are analyzed with Porter’s ﬁve forces framework and chapter 2 closes with an inter- nal analysis in Section 5.3 using the VRIO framework and a comparison of airline speciﬁc measurements with the peer group.

5.1 PESTEL Analysis

It is important to analyze the macro environment for Icelandair to understand the external factors aﬀecting the company. The main objective of the macro analysis is to detect external factors that can aﬀect Icelandair’s potential earnings growth and risk. As an Airline Icelandair is highly dependent on these external factors and can do little to aﬀect or inﬂuence them. It can only adjust its operation to better adapt to each situation. The Macro analysis is conducted using a slightly modiﬁed version of the PESTEL framework. Using the PESTEL model relevant factors are grouped into categories of Political, Economic, Sociocultural, Technological, Environmental and Legal. Each category is then analyzed and the impact of possible future changes estimated. Since Icelandair operates in the airline industry it is concluded that legal issues are better dealt with under the Political section. These topics are dependent upon each other and legislation in the industry is often politically inﬂuenced and motivated. Therefore, the Macro environment is analyzed using a PESTE model. It is important to keep in mind throughout this analysis that the categories are not mutually exclusive and topics discussed are often relevant to more than one category. The PESTE model ﬁts well to analyze the macro environment of an airline as they are aﬀected by political decisions, are subject to strict regulations and highly dependent on economic trends.

5.1.1 Political & Legal issues

Deregulation

“Very few global industries are as deeply aﬀected by changes in the international and domestic regulation environment as the airline industry.” (Belobaba, P. , Odoni, A. R. and Barnhart, C., 2009, p. 19). The airline industry has been subjected to deregulation for the past few decades which has changed the landscape of the whole industry. The long-term trend seems to be in the direction of further deregulation and liberalization of global airlines (Belobaba, P. , Odoni, A. R. and Barnhart, C., 2009). This trend has led to more competition among global 16 STRATEGIC ANALYSIS airlines and been the main source for the growth of low cost airlines. The low cost sector has been growing rapidly worldwide for some period now, with Southwest and JetBlue in the US and Ryanair and easyJet in Europe having paved the way for an explosion of new-entrant, Low-Cost Carriers (LCC) around the world (Doganis, 2006). Although due to Iceland’s geographical position Icelandair may be marginally shielded from some of the competition, it is still aﬀected by the LCC trend. EasyJet, SAS, Norwegian and Wizz, among others all have Iceland as a destination. But Icelandair’s main competition in Iceland has been local low cost airlines, ﬁrst Iceland Express founded in 2002 and now WOW Air which in 2012 acquired Iceland Express’s operations and network. Low-cost airlines are certainly not all successful and most of them will in fact not survive beyond the short to medium term. However, the low-cost business model appears to be working and the successful LCC will continue to capture market share and force prices down. Further liberalization of international air services will increase LCC’s growth in new markets (Doganis, 2006).

Labor contracts and Unions

In May 9th 2014 Icelandair’s pilots halted work and began a 12-hour strike. They demanded a pay increase of 2,8% on basic salary plus increases on bonuses. If these demands were not met they threatened two additional 12 hour strikes. Strikes are very costly for an airline and it is estimated that Icelandair’s loss was between 1,5 and 1,7 billion ISK, this is not factoring in any aﬀect this instability had on future booking’s and possible revenue (Visir.is, n.d.-b). On May 15th 2014 the Icelandic government passed a law prohibiting the strike and gave Icelandair and the pilots’ union 15 days to come to an agreement. If not, the contracts would be ﬁnalized through arbitration. A few days from the deadline, on May 28th, the parties came to an agreement, very close to the union’s demands. The new contract is valid until September 30th 2017 (Visir.is, n.d.-c, n.d.-a). It remains to be seen what will happen in next year’s contract negotiations, but it is obvious that the unions, both pilot and ﬂight attendance, are strong in Iceland. It is also evident that the Icelandic government will step in and meddle if it deems it necessary. If this instability continuous and ﬂights have to be canceled or delayed every few years due to strikes, it could be damaging to Icelandair’s image and aﬀect passengers’ choice.

5.1.2 Economic issues

The World Economy

As previously discussed the airline industry is highly correlated with shifts in the world economy and trade cycles. The airline industry is cyclical and its cycles appear to be closely linked to the world economic shifts (Doganis, 2006). We can see from Figure 5-1 that demand for airline tickets across the world from 1980 until 2014 seems to follow the world economic climate. When GDP is growing, airlines carry more passengers and when the growth slows down airlines tend to carry fewer passengers as well. We can further see the correlation in Figure 5-2, where the data has been normalized in order to be able to see how number of passengers carried follows the growth in GDP. 5.1 PESTEL ANALYSIS 17

20% GDP Passengers

Year-to-yearchange

Figure 5-1: World GDP and Passengers carried globally, showing percentage change. Own creation, data from (The World Bank, 2015; International Monetary Fund, 2016).

700 GDP Passengers

Normalized values Normalized 300

Figure 5-2: Nominal World GDP and Passengers carried worldwide, Data normalized to show correlation. Own creation, data from (The World Bank, 2015; International Monetary Fund, 2016).

It is no easy task to predict global economic trends, with so many diﬀerent factors aﬀecting it, and no attempt is done as part of this study to do so. Instead it can be useful to look at pre- dictions from reputable organization. For example, the International Monetary Fund (IMF) estimates an average growth in world GDP from 2016 until 2020 to be 3.8% (International Monetary Fund, 2016). Estimates should obviously be taken for what they are, as nobody can predict the future. Further, since the airline industry is so correlated with the economy, it is highly sensitive to events such as war, terrorist attacks and oil crisis to name a few, which can cause quick macroeconomic shifts. These are unpredictable events and therefore 18 STRATEGIC ANALYSIS impossible to forecast accurately where and when they will occur. We can see that as an airline with 76% of its revenues in 2015 originating outside of Iceland, Icelandair is highly aﬀected by global economic shifts that they have no power over and can only do their best to adjust to. In 2015, Icelandair’s revenues originating in Iceland amounted to 24% of total revenues and most of their non-current assets are located in Iceland. Therefore Icelandair is also very dependent on the Icelandic economy. This was particularly evident in the years following the crisis of 2008. As discussed in Section 3.2(History), Icelandair needed to perform a ﬁnancial restructuring, extending maturities on debt and adding additional equity. But this economic shift also brought new opportunities to the company. Before the collapse, Iceland was a rather expensive country for foreigners to visit, the Icelandic Krona was strong compared to the Dollar and the Euro. Since the collapse Iceland has become more competitive and attractive to foreigners and when the world economy started to grow again, demand for Iceland as a destination soared. There are of course other factors than the depreciation of the Icelandic Krona that make Iceland a popular tourism destination now. Figure 5-3 shows international visitors to Iceland from 2009 to 2014. In 2014, 97% of the visitors arrived by plane (not all with Icelandair) (Ferdamalastofnun, 2015). From the graph we can see that tourists visiting Iceland have doubled during these ﬁve years.

d Cruisesd 700.000

International Visitors an Visitors International 200.000

- 2010 2011 2012 2013 2014

Figure 5-3: International visitors to Iceland, from 2009 to 2014. Own creation, data from (Ferdamalastofnun, 2015).

Another key factor aﬀecting the airline industry is the price of fuel. For most airlines jet fuel is the largest single operating cost and Icelandair is no exception, with aircraft fuel accounting for 25% of its operating expenses in 2015 (Icelandair Group hf, 2016b). It is therefore easy to see how developments in jet fuel prices can impact the company. Figure 5-4 shows the development in jet fuel prices during the last two decades. 5.1 PESTEL ANALYSIS 19

4,5 Jet Fuel 4 3,5 3 2,5 2 1,5 1 0,5

Price per gallon (USD) 0

Figure 5-4: Jet fuel per gallon monthly prices in US dollars. Own creation, data from (Indexmundi, n.d.).

The price of jet fuel is not surprisingly highly correlated to oil prices and mirrors them almost exactly. This can be seen very clearly in Figure 5-5, where jet fuel prices have been converted from price per gallon to price per barrel in order to compare to crude oil prices.

180 Jet Fuel Crude Oil 160 140 120 100 80 60 40

Price per Barrel (USD) 20 0

Figure 5-5: Jet fuel and Crude Oil prices per barrel, monthly prices in US dollars. Own creation, data from (Indexmundi, n.d.).

This strong correlation between the commodities indicates that price developments for crude oil will impact jet fuel prices and that oil price forecast can be used to predict future jet fuel expenses. Many factors aﬀect and inﬂuence crude oil prices, for example: political instability, wars, global economic outlook, and supply and demand, among others. Therefore, oil prices are volatile and can often be extremely hard to predict. Historically crude oil prices have varied a lot as can be seen from Figure 5-6. The price of oil shot up dramatically on two occasions in the 1970s, during the Middle East crises. First in 1973-4 when prices more than doubled and then again in 1979 when they again doubled. These high fuel prices were one of the major causes for the cyclical downturn in the early 1980s in the airline industry (see Figure 3-6). The sharp drop in 1986 explains the high proﬁts in the late 1980s. Between 1986 and 2002, oil- and jet fuel prices stabilized at a value little less than half the price 20 STRATEGIC ANALYSIS prevailing during the early 1980s (Doganis, 2006). Oil prices rose sharply in the years leading up to the ﬁnancial collapse in 2008 when they saw a sharp decline. Prices rose again reaching slightly lower price than before in 2011 until 2014 when they began to decline. Currently oil prices have been declining very rapidly with prices reaching a 12-year low of $26 per barrel in January 2016. This recent fall in oil prices reﬂect concerns of over-supply in the market, intensiﬁed by additional supply from Iran. Demand outlook appears to have weakened as well in key energy-consuming countries and storage levels are near record highs. Hedging will delay some of the beneﬁts in the airline industry but if these prices are sustained IATA estimates it would reduce the industry’s annual fuel bill by approximately $12 billion in 2016 (International Air Transport Association, 2016).

100 90 80 70 60 50 40 30 20

Nominal average Nominal average annual price 10 0

Figure 5-6: Average annual price (USD) of crude oil in nominal values not adjusted for inﬂation. Own creation, data from (Inﬂationdata, n.d.).

Declining fuel prices are good for airlines as it lowers their operating costs. Icelandair is like other airlines exposed to the risk of fuel prices increasing and chooses to minimize this risk by employing a hedging strategy. Their current strategy is to hedge between 40% and 60% of fuel consumption 12 months forward. With this strategy the company aims to provide protection against sudden and signiﬁcant increases in oil prices, while still being able to take advantage of a substantial fall in prices. At yearend 2015, the company has hedged 60% of an estimated 12 months exposure with swaps (Icelandair Group hf, 2016b). At the date of analysis (8.4.2016), crude oil is trading around $38 per barrel, a signiﬁ- cant increase from its lowest point in mid-January when prices were around $26 per barrel (Bloomberg, n.d.-b). As previously stated oil prices can be extremely hard to predict and the future of oil is highly uncertain, some forecasts expect the price to continue declining down to $20 per barrel while others are expecting a rise to $60 per barrel. A very signiﬁcant rise in 2016 seems unlikely though, given the record of oil inventories (International Air Transport Association, 2015) but as will be discussed in Chapter8(Forecasting) operating costs are expected to increase as oil prices rise again.

While aircraft fuel is Icelandair’s biggest single operating expense, total salaries and other personnel expenses aggregated together represent a larger cost. Icelandair employed an av- erage of 3.384 full time employees in 2015 (Icelandair Group hf, 2016b). As a group total 5.1 PESTEL ANALYSIS 21 salaries and other personnel expenses accounted for 30% of the company’s operating expenses (Icelandair Group hf, 2016b). With fuel prices declining, labor costs will represent a higher share of total operational costs. Labor costs are not entirely an external factor management cannot aﬀect. Managements inﬂuence will be discussed in the internal analysis in Section 5.3. However, some aspects of labor costs are out of the company’s hands and all management can do is react. Labor costs usually follow growth in the economy in cyclical upturns, but due to strong union powers they can be diﬃcult to reduce either through lowering wages or by laying of staﬀ, when the economy turns. This can be dangerous if labor costs rise so high during the upturn that they become unsustainable in the next downturn. As previously discussed, Icelandair dealt with pilots striking in 2014 and with a strong union culture in Iceland, the company can expect similar situations when labor contracts are re- negotiated.

Currency risk

Icelandair is exposed to currency risk arising from its business dealings in diverse currencies. The company seeks to reduce its exposure to currency mismatch in the cash ﬂow by matching receipts and payments in each individual currency. After that any mismatch still left, is then dealt with using currency trade within the Group before turning to outside parties. For Icelandair the biggest currency mismatch has been where annual US dollar cash inﬂows fall short of outﬂows. This deﬁcit is mainly due to fuel costs, lease payments and funding related payments. Historically this deﬁcit has been approximately 100 million dollars, but due to a period of organic growth and falling fuel prices the gap has been shrinking and is expected to decrees further in the near future (Icelandair Group hf, 2015). Icelandair’s hedging policy regarding currency risk is to hedge 50-80% of net currency exposure 9-12 months forward using spot and forward contracts (Icelandair Group hf, 2016a).

Interest rate risk

Airlines are aﬀected by interest rate changes, both in their home market and globally. Interest rate increases by central banks will normally have negative eﬀects on airlines. An increase in interest rates will result in higher debt payments for Icelandair as a large part of Icelandair’s outstanding loans is directly related to aircraft ﬁnancing and denominated in US dollars. The company hedges 40-80% of its net interest rate cash-ﬂow exposure of long-term ﬁnancing with up to 5-year horizon. Foreign loans are currently hedged against interest rates ﬂuctuations using ﬁxed-rate loan contracts or swap contracts, where a ﬂoating rate is exchanged for ﬁxed (Icelandair Group hf, 2015). On the other hand, a reduction of interest rates by central banks could have a positive eﬀect, both in terms of lowering debt payments and increasing consumption in the economy.

5.1.3 Sociocultural issues

Now that air travel has become more aﬀordable and no longer a luxury reserved for the rich there has been a shift in the customer demographic and with it a change in buying behavior. Passengers are choosing lower cost ﬂights, especially for shorter distances. This change has 22 STRATEGIC ANALYSIS relatively beneﬁted the low cost carriers the most but increasing number of passengers is surely positive for the whole industry. As seen in Figure 3-5 (Page 11), passengers carried per year has increased rapidly during the last decades and ICAO forecasts an average annual growth rate of 4.5% until 2030 (International Civil Aviation Organization, n.d.). While Icelandair is not an LCC its prices are still very competitive and the company possesses a strong brand in Iceland, known for quality services with reliability. Icelandair’s number of passengers has been increasing very steadily and in February 2016 the company carried 181.000 passengers, an increase of 26% from last year’s February (Icelandair Group hf, n.d.-f). With this increase in demand Icelandair is still maintaining its reputation for punctuality and had the highest ratio of take-oﬀs and landings on time, 75%, in Iceland’s airport in Keﬂavik in February 2016 (Vidskiptabladid, n.d.). With continued demand for Iceland as a destination and passengers preferring cheaper ﬂights, Icelandair will likely face increasing competition from LCC adding Iceland as a destination to their network and driving down prices. Icelandair already faces competition from LCC as many of them are increasing their operations in Iceland.

5.1.4 Technological issues

Technology has played a big part in the improvement of the airline industry in recent years. The development in computer reservation systems has brought dramatic changes in airline distribution, shifting from traditional travel agencies to the internet for booking and ticketing. Internet distribution channels provided airlines with an opportunity to have more control over the distribution of their own product and simultaneously reduce distribution costs. Electronic tickets (e-tickets) and web check-ins have further decreased costs. By enabling passengers to check in for their ﬂights, select seats and other features either online or through self-check-in machines at airports allows for faster passenger processing and reduces manual labor required and costs for airlines (Belobaba, P. , Odoni, A. R. and Barnhart, C., 2009). Technological advances in aircraft engineering have produced better and more eﬃcient plains with higher comfort levels. Eﬃcient plains decrees fuel consumption lowering operating costs and reduce CO2 emission making them more environmental friendly. Newer and better build airplanes should also carry fewer technical problems and less maintenance, reducing delays and cancelations due to technical problems. Innovations in technology may also produce threats for the air travel industry. Better and more personal communications through the internet with emails, live message chats and video conferencing may have reduced the need for travel in order to do business. This is likely to be true especially with regards to intra-company dealings. This has not been a major issue for the industry and it is unlikely that this is something the airlines should need to worry too much about. Virtual reality and hologram technology may possess further threats to the industry, but more likely have a minimal impact on airlines.

5.1.5 Environmental

Air transportation is highly sensitive to environmental factors such as violent weather storms and natural disasters. Bad weather can cause delays and cancelations, which in turn increase costs for airlines. 5.2 PORTERS FIVE FORCES 23

Natural disasters can also be very costly to an airline as was evident in April 2010 when the Icelandic volcano Eyjafjallajokull erupted. Volcanic ash paralyzed much of Europe’s air traﬃc, leaving millions of passengers stranded all over the world. Icelandair scrambled to keep its network open as long as possible and in order to bring passengers closer to their destinations special ﬂights were organized to the few European airports still open. As European air space was opening up Iceland’s airport in Keﬂavik, Icelandair’s hub, closed down. Icelandair moved its whole hub operation to Glasgow airport along with 200 of its staﬀ to be able to run its temporary operations. The situation lasted for 10 days and during that period 36 ﬂights per day and 4-6 thousand passengers were carried with shuttle ﬂights to Akureyri airport in the north of Iceland with busses running around the clock to Reykjavik. Icelandair’s eﬀorts resulted in only 20% of passengers needing to cancel their trips and minimal compensation requests (Icelandair Group hf, n.d.-a). The Eyjafjallajokull disaster posed other kinds of threats to Icelandair, it had changed the perception of Iceland as a tourist destination, Iceland was now considered unsafe and dan- gerous. Icelandair saw an instant decrease in demand with ﬂights and hotel bookings being canceled. With tourist arrivals decreasing by 22% in April, Icelandair along with the Icelandic government launched a PR campaign to try to revitalize bookings and avoid a disaster in the summer high season. The campaign was successful and the number of tourists visiting Iceland equaled the year before (Icelandair Group hf, n.d.-a).

5.2 Porters Five Forces

This chapter looks to identify key features of the airline industry that determine the strength of the competitive forces at work in the market and ultimately Icelandair’s potential prof- itability. In order to better understand and analyze the level of competition in the airline industry, Porter’s Five Forces framework is used. Whereas the PESTEL framework analyzed Icelandair’s macro environment, the Five Forces framework focuses on the micro environment and highlights forces aﬀecting the competition in the industry. Porter’s Five Forces are as follows: Threat of new entrants, Bargaining power of suppliers, Bargaining power of buyers, Threat of substitutes and Rivalry among existing ﬁrms. The Five Forces can be seen in Fig- ure 5-7. Porter’s framework is generally used to analyze a speciﬁc industry, here it will be slightly modiﬁed in order to better show Icelandair’s position in the industry.

5.2.1 Threat of new entrants

The airline industry is both labor and capital intensive, making it relatively hard to enter. Starting an airline requires big initial investments with high costs in setting up the ﬂeet, hiring staﬀ, buying fuel, maintenance and other various costs that will occur. But as with most industries, when borrowing is cheap more airlines will be formed. Icelandair has had competition from an Icelandic low-cost airline for over a decade without signiﬁcant loss of market share or decreasing proﬁts. A bigger threat to Icelandair is other established airlines adding Iceland as a destination and/or ﬂying the same routes as Icelandair. This is already a reality, with tourism in Iceland increasing so rapidly. Already 25 airlines have conﬁrmed their slot at Keﬂavik airport for the summer of 2016, this is a 25% increase from 2015 when 20 airlines landed in Keﬂavik and in 2010 there were only 10 (Mbl.is, n.d.). The biggest barrier of entry for airlines adding Iceland to their route network is airport slots. 24 STRATEGIC ANALYSIS

Figure 5-7: Porter’s Five Forces. Own creation, data from (Porter, 1980).

An airport slot is a permission granted by the airport to an airline, allowing the use of its infrastructure to arrive or depart at a speciﬁc date and time (International Air Transport Association, 2014). Iceland only has one airport that can support international traﬃc and the airport can only allocate slots with in its capacity. Airport slot allocation is regulated by IATA. According to IATA’s worldwide slot guidelines an airline is entitled to retain a series of slots on the basis of historic precedence. This means that if a series of slots was operated at least 80% of the time during the previous period, an airline is entitled to retain its slots. Further, slots may not be withdrawn from an airline holding rights to a slot to accommodate new entrants (International Air Transport Association, 2014). This is an advantage to Icelandair as they have a long history at Keﬂavik airport and operate many of the best slots. The fact that Keﬂavik airport is Iceland’s only international airport adds to this advantage as airlines do not have an alternative airport to secure slots at.

5.2.2 Bargaining power of buyers

Buyers or customers of the airline industry can be divided into two groups, leisure- and business travelers. For most airlines leisure travelers represent a bigger portion of ticket sales. Leisure travelers are generally speaking more ﬂexible regarding time and date and more price sensitive. For this group of customers switching costs are low and the price is frequently the deciding factor when it comes to choosing between carriers. As discussed in the technology section of the PESTEL analysis, technological advances have increased bargaining power of airline customers. Few travelers contact an airline directly, but instead look for ﬂights on websites comparing rates between all carriers for a given trip. This price transparency and the eﬀortlessness of gaining this information have lowered switching costs for travelers drastically. Often times the cheapest carrier is chosen by leisure travelers, driving up sales for LCC. Business travelers are generally less ﬂexible on time and date. They are often frequent ﬂyers who prefer access to lounges or fast tracks and usually corporations have deals with airlines. They represent a smaller portion of airlines sales, but are still important for a network 5.2 PORTERS FIVE FORCES 25 airline such as Icelandair. Business travelers are often buyers of the more expensive seats and premium services, as well as being less seasonal and therefore oﬀer both higher margins and increase stability in sales. Both these groups have quite high bargaining power over airlines. With a dominant position and a strong brand, Icelandair may have an advantage over its competitors in terms of customers bargaining power, regarding ﬂights to and from Iceland.

5.2.3 Bargaining power of suppliers

According to Porter(1980) the bargaining power of a supplier group is substantial if it is dominated by a few companies and is more concentrated than the industry it sells to. This is the case in the airline industry, as there are only two major global aircraft manufacturers, Boeing and Airbus, selling to most airlines in the world. This oligopoly in aircraft manu- facturing is not favourable to the airlines as it wields considerable inﬂuence on the prices and terms the airlines receive. On the other hand, airlines are a major customer of both the big aircraft manufacturers and sales to them represent a signiﬁcant portion of their income. The bigger the airline the more bargaining power and the big ones certainly have bargaining power. Icelandair operates a ﬂeet of Boeing aircrafts on its international route network and is unlikely to have much bargaining power when it comes to purchasing aircrafts. Changing from Boeing to Airbus would be costly and unlikely Icelandair will opt for that. Labor must be recognized as a supplier as well. As discussed in the PESTEL section, Ice- landair’s labor is tightly unionized and has leverage to bargain for high wages and compen- sation. This eats away a signiﬁcant fraction of the potential proﬁts for the company.

5.2.4 Substituting products

For the airline industry there are a number of substitutions available, alternative transporta- tion like driving, busses, trains, ferries etc. can all be seen as substitutes for air travel. But since Iceland is an island in the middle of the Atlantic Ocean there is only one alternative to air travel and that is sea travel. A number of diﬀerent cruses dock in Iceland, but as they represent a very diﬀerent form of traveling than ﬂying they should not be considered a direct substitution. A closer substitution is a ferry, there is currently one ferry carrying passengers to and from Iceland. The ferry sails between Iceland and Denmark each week with a stop in the Faroe Islands. Given the time it takes to sail to Iceland, it is very unlikely that it will be any kind of threat to air travel in the near future. Further, most of Icelandair’s revenues come from trans-Atlantic ﬂights, carrying passengers between north America and Europe. Unless some unforeseen technological advances, air travel seems to be the best and most eﬃcient way of transportation on Icelandair routs.

5.2.5 Rivalry among existing ﬁrms

The level of competition is high in the airline industry. As previously discussed the liberation of the industry led to a rapid increase in low cost carriers, escalating an already competi- tive market to another level. The ﬁerce competition in the airline industry stems from the lack of diﬀerence between airlines. In general airlines ﬂy to the same destinations from the same airports for similar prices with the same cramped seats. This lack of diﬀerentiation makes air travel in general a standardized service, putting pressure on price. Icelandair faces 26 STRATEGIC ANALYSIS competition from airlines ﬂying through Iceland on their way across the Atlantic and those with Iceland as a destination on their network. As discussed in the section on new entrants, Icelandair’s competition is growing rapidly. Icelandair manages these competitive threats with marketing campaigns, focusing on brand awareness and the company’s longstanding reputation for quality services.

5.2.6 Summary of Porter’s 5 Forces

It is clear that the airline industry is very competitive and that airlines face many challenges trying to maintain proﬁtability. Table 5-1 shows a summary of the Porter’s ﬁve forces analysis, ranking the strength of each force in the market.

Table 5-1: Summary of Porter’s Five Forces.

Porter’s ﬁve forces Low Mid High Threat of new entrants X Bargaining power of buyers X Bargaining power of suppliers X Substituting products X Rivalry among existing ﬁrms X

Threat of new entrants for Icelandair is considered low as well as substituting products. Bargaining power of buyers rank as moderately high as buyers have bargaining power through low switching costs, but it is not signiﬁcant in Icelandair’s case. Icelandair has a single supplier of aircraft, with very limited options to switch. Icelandair’s labor force is unionized and powerful in its wage negotiations. Bargaining power of suppliers is therefore considered high. There is high rivalry among existing ﬁrms, with air travel such a standardized product; airlines therefore compete hard to entice customers.

5.3 Internal Analysis

Until now the focus of the strategic analysis has been on the company’s environment, in this section the focus is shifted onto the company itself. The objective of the internal analysis is to get a better understanding of Icelandair’s internal resources and the company’s capability to utilize its resources to generate value. To analyze Icelandair’s internal factors a resource based theory, VRIO by Barney(1995) is used. The VRIO framework is a tool used to analyze the internal resources and competencies of a company in order to ﬁnd out if the company possesses a competitive advantage and whether it can be sustained (Rothaermel, 2012). A competitive advantage is any feature of the company that allows it to be proﬁtable beyond its competitors. Following the VRIO analysis, Icelandair’s resource utilization is compared to its peer group using airline industry speciﬁc measurements in Section 5.4.

5.3.1 VRIO Analysis

In a resource based model as the VRIO, the company’s resources are seen as the most im- portant aspect in gaining an advantage over competitors. A company’s resources include 5.3 INTERNAL ANALYSIS 27 all of the ﬁnancial, physical, human and organizational assets used by the company to de- velop, manufacture, and deliver products or services to its customers (Barney, 1995). In this section ﬁnancial resources will be left out as they will be dealt with in greater detail in Chapter6(Financial Analysis). The name VRIO is an acronym for: Valuable, Rare, Imitability and Organization. Each of these refer to a question that needs to be answered in order to ﬁgure out if a resource can be a source of competitive advantage. The ﬁrst question to be answered is whether Icelandair’s resources and capabilities add value? Next is the question of rareness: How many competing ﬁrms already possess the valuable resources and capabilities of Icelandair? In order for resources to be deemed as a source of sustainable advantage it must be rare among other airlines. This does not mean that common resources are not valuable, they may in fact be vital to the company, just that they do not create a competitive advantage. Then there is a question of imitability: Do other companies without this valuable resource or capability face a cost disadvantage in obtaining it compared to the ﬁrms that already possess it? A company possessing a valuable and rare resource can gain a competitive advantage if competing ﬁrms face a cost disadvantage in imitating these resources. Lastly the question of organization needs to be answered: Is the company organized to exploit the competitive potential of its resources (Barney, 1995)? Figure 5-8 shows the process of analyzing a company’s resource with the VRIO framework.

Competitive Valuable? Yes Rare? Yes Imitable? Yes Organized? Yes Advantage

No No No No

Temporary Temporary Competitive Competitive Competitive Competitive Disadvantage Parity Advantage Advantage

Figure 5-8: VRIO analysis process. Own creation, data from (Rothaermel, 2012).

Tangible Resources

Icelandair’s physical or tangible resources are ﬁrst and foremost the company’s aircraft ﬂeet. The group operates in total 43 aircrafts, of which 35 are owned directly, while the rest is leased or chartered (Icelandair Group hf, 2016b). The ﬂeet and ﬂight equipment is the company’s largest and most valuable operating asset by far, representing 84% of operating assets at yearend 2015. Other physical resources are mostly buildings such as a maintenance hangar, freight and service buildings in Keﬂavik and other oﬃce buildings in Reykjavik along with other property and equipment (Icelandair Group hf, 2016a).

Intangible Resources

Icelandair possesses a number of intangible resources. Along with its longstanding brand, the company’s route network and airport slots, as previously discussed, are very important for Icelandair. Iceland’s geographical positioning is of signiﬁcant importance for Icelandair as it allows the company to be in reach of two major continents. Icelandair currently holds 28 STRATEGIC ANALYSIS a dominant position in the home market and Icelandair has done well to maintain a strong reputation in Iceland and has been gaining awareness in other parts of the world. A signiﬁcant part of that advantage is the airport slots Icelandair has rights to and the rules regarding those slots that allows Icelandair to keep them as long as they are able to use them. Another immaterial resource that is of importance to Icelandair is its human resource. The company’s response to the natural disaster in 2010 when Eyjafjallajokull erupted closing down much of Europe’s air travel is a testimony to both managements abilities and skilled labor force (see Section 5.1.5(Environmental)).

As seen in Table 5-2, three resources are identiﬁed as a source of sustainable competitive advantage. All three work closely together to secure Icelandair’s strong position as a market leader in ﬂights to and from Iceland. Icelandair has a ﬂeet that ﬁts its size and purpose well, but it is not a rare resource and therefore cannot be identiﬁed as a source of competitive advantage, it is however along with the staﬀ and certain buildings very valuable for the company. In light of how well Icelandair handled the ﬂight crisis caused by Eyjafjallajokull in 2010 and the success in recent years, management and brand are identiﬁed as a temporary competitive advantage as they can be attained without much cost by some competitors.

Table 5-2: Summary of VRIO analysis.

Resource Valuable Rare Costly Exploited Competitive to by the implications imitate organization Aircraft ﬂeet Yes No - - Competitive Buildings and properties Parity Qualiﬁed staﬀ Management Yes Yes No - Temporary Brand and reputation competitive advantage Dominant position in Iceland Yes Yes Yes Yes Sustainable Route network competitive Airport slots advantage

5.4 Industry Speciﬁc Analysis

In this section, Icelandair is compared to its peer group based on measurements speciﬁc to the airline industry. These measurements are speciﬁc to airlines and are used to show how eﬃciently resources are being used. Comparing Icelandair’s measurements to those of its peer group will give an image of where it stands relative to its peers. 5.4 INDUSTRY SPECIFIC ANALYSIS 29

5.4.1 Available Seat kilometer

Available seat kilometer (ASK) is an essential measurement of an airlines passenger carrying capacity. ASK is deﬁned as one seat, empty or ﬁlled, ﬂying one km and is calculated as:

ASK = km flown × available seats

It is clear from Figure 5-9 that Icelandair is very small in terms of capacity relative to its peer group. But Icelandair has been increasing its capacity year after year and in 2015 its capacity amounted to 11.083,7 million ASK an increase of 106% from 2010. With the addition of the new aircrafts in 2016 and then in 2018 the capacity is set to increase further in the coming years.

0 2010 2011 2012 2013 2014 2015

Icelandair Airberlin Finnair SAS Norwegian

Figure 5-9: Available seat km for Icelandair and the peer group in millions. Own creation, data from (Bloomberg, n.d.-a).

5.4.2 Revenue Passenger kilometer

Revenue passenger kilometer (RPK) is a measurement of an airlines passenger traﬃc. RPK is a unit of one passenger ﬂying one km and is calculated as the multiple of distance and seats sold: RPK = km flown × seats sold

RPK is a good measurement along with ASK, as a decreasing ASK can be good if an airline is cutting down on its less proﬁtable routes. RPK will also show whether the increasing supply is met with demand. Figure 5-10 shows that Icelandair’s traﬃc is signiﬁcantly less then its chosen peer group, but has been growing at a faster pace than its peers, except Norwegian. 30 STRATEGIC ANALYSIS

Figure 5-10: Revenue Passenger km for Icelandair and the peer group in millions. Own creation, data from (Bloomberg, n.d.-a).

5.4.3 Load Factor

Load factor is a measurement of capacity utilization of airlines. It measures how eﬃciently an airline ﬁlls its seats and generates revenue through fares. The load factor is calculated by dividing RPK with ASK, showing how much of the total capacity is being utilized to generate earnings for the airline.

RPK Load factor = ASK The load factor is a percentage based measurement and a load factor of 100% means that all available seats have been sold.

Load Load factor(%)

65,00 2010 2011 2012 2013 2014 2015

Figure 5-11: Load Factor for Icelandair and the peer group. Own creation, data from (Bloomberg, n.d.-a).

Icelandair has been increasing its load factor year from year, with 2013 as the only exception. 5.4 INDUSTRY SPECIFIC ANALYSIS 31

Figure 5-11 shows that in 2015 Icelandair’s load factor was 83% and 80% on average between 2010 and 2015. Only Air berlin shows a higher load factor average for the period. For the period every one of the selected airlines has increased its load factor.

5.4.4 Yield per Passenger kilometer

The yield is a measurement of the revenue per km an airline generates. The Load factor only tells half the story, although utilizing the capacity is important a plain full of underpriced tickets is not ideal for an airline. The yield tells the other half of the story, showing how much revenue the airline is generating per each passenger km, calculated as:

P assenger Revenue Y ield = RPK

Yield km Yield passengerper

0,00 2010 2011 2012 2013 2014 2015

Figure 5-12: Yield per Passenger km for Icelandair and the peer group in millions. Own creation, data from (Bloomberg, n.d.-a).

From Figure 5-12, it is clear that SAS is generating signiﬁcantly higher revenue per passenger km than other selected airlines, especially from 2010 to 2013 when they start to decline. This high yield is however oﬀset by the lower Load Factor for SAS seen in Figure 5-11. Norwegian being a low cost airline only shows signiﬁcantly lower yields during 2014 and 2015. Icelandair has managed to maintained its yield through the period while most of its peers have declined.

5.4.5 Cost per Available Seat kilometer

The load factor and yield show the revenue side for airlines, but equally important are the costs as an airline will not proﬁt if costs are too high. The airline industry is very cost heavy, with both a high ﬁxed costs and variable costs. The cost per available seat km (CASK) is a measurement of cost per each seat km, measuring the cost per available seat empty or ﬁlled, calculated as:

Operating Expenses CASK = ASK 32 STRATEGIC ANALYSIS

Figure 5-13 shows that Norwegian has signiﬁcantly lower cost over the period than the others, this is to be expected given their low cost strategy and overall lower yields. Costs for the whole group are decreasing over the period and in 2015 Icelandair has 33% lower CASK than in 2010. As discussed in Section 5.1.2, fuel prices have declined signiﬁcantly and explain most of the decrease in cost.

CostperASK 9,00

5,00 2010 2011 2012 2013 2014 2015

Figure 5-13: Total Cost Per Available Seat km for Icelandair and the peer group. Own creation, data from (Bloomberg, n.d.-a). 6| Financial Analysis

In this chapter, Icelandair’s ﬁnancial standings will be analyzed, both independently and chosen items compared to the peer group presented in Chapter4. The analysis is carried out with two approaches, ﬁrst through a trend- and common size analysis in Section 6.2& Section 6.3 and in Section 6.4 Icelandair’s proﬁtability is analyzed in an in-depth analysis of the return on common equity (ROCE) and compared to the selected peer group.

6.1 Financial Statement Reformulation

The ﬁrst step in analyzing Icelandair’s ﬁnancial statement is reformulating them. Since Icelandair’s ﬁnancial restructuring was completed in 2011 (see Section 3.2(History)), ﬁnancial statements from 2012 to 2015 are analyzed and used for the valuation. This period is chosen as it gives the most accurate picture of Icelandair’s current operations. The reformulation will follow the approach laid out in Penman(2013) “Financial Statement Analysis and Security Valuation”. Reformulation of each of the statements will be given in more detail in the following sub sections and Icelandair’s reformulated ﬁnancial statements for the period from 2012 until 2015 can be found in Appendix B.

6.1.1 Reformulation of the Statement of Shareholders’ Equity

The statement of shareholders’ equity is a summary statement, explaining how equity has changed over the year. The statement shows all transactions that aﬀect shareholders’ equity as well as a beginning and ending equity balance for the year. It is the ﬁrst ﬁnancial statement that should be analyzed as it ensures that all aspects of the business that aﬀect shareholders’ equity are included in the analysis to value the equity (Penman, 2013). As discussed in the valuation methodology in Chapter2, the valuation will center on the Residual Operating Income (ReOI) model. It is therefore important that the reformulation is on a clean surplus basis and the income used for valuation needs to be comprehensive income, if not value will be lost in calculations (Penman, 2013). The equity statement has to be reformulated so that the clean surplus relation holds. The clean surplus relation:

CSEt = CSEt−1 + NIt − dt , where CSEt represents common shareholders’ equity at time t and CSEt−1 is the same for the previous period, NIt is net income at time t and dt denotes net transactions with shareholders during time t. A clean surplus accounting equity statement is one that has no income other than net income from the income statement (Penman, 2013). Then all changes in the book value of equity except transactions with common shareholders go through the income statement (Christensen & Feltham, 2009). The reformulation of the equity statement is done in three steps. First step is to restate begin- ning and ending balances for the period for items that are not part of common shareholders’ equity: this includes preferred shares, non-controlling interests and dividends payable. For Icelandair, the only adjustment needed is for non-controlling interests. Next step is to calcu- late net transactions with shareholders. Icelandair’s only transaction with shareholders during 34 FINANCIAL ANALYSIS the period from 2012 to 2015 was in the form of dividend payments; no stock repurchases or share issues. Third and ﬁnal step is to calculate the comprehensive income. Income reported outside net income in the income statement is referred to as other comprehensive income. For Icelandair other comprehensive income consists of: currency translation diﬀerences and items showing the eﬀect of hedges. Comprehensive income is the sum of net income and other com- prehensive income (Penman, 2013). Icelandair does not have stock based compensation and there are no outstanding options held by employees, therefore there is no hidden dirty-surplus to account for.

The reformulation of the equity statement gives a clearer picture of the growth in common equity. And the split between comprehensive income and transactions with shareholders distinguishes the source of the growth, whether it stems from investments made by the owners or from running the business (Penman, 2013).

6.1.2 Reformulation of the Balance Sheet

Balance sheets classify assets and liabilities into two categories, current and non-current, de- pending on: liquidity for assets and time to maturity for liabilities. This type of classiﬁcation is more suitable for credit analysis rather than for equity analysis. For equity analysis the focus is on assessing a company’s ability to generate proﬁts. To facilitate that, the balance sheet is reformulated into operating and ﬁnancial assets and liabilities. As it is the operating activities that create value for shareholders and not how the company ﬁnances itself. Fur- ther, ﬁnancial assets and liabilities are typically close to market value in the balance sheet and therefore do not need to be valued, while operating assets and liabilities are generally not. Operating Assets (OA) and Operating Liability (OL) are those assets and liabilities that are involved in the business of the company. Net Operating Assets (NOA) is the diﬀerence between the two: NOA = OA − OL

Financial Assets (FA) and Financial Liabilities (FL) are those assets and liabilities involved in ﬁnancing the company, raising funds for operations and distributing excess funds from operations. Financial assets and liabilities net to Net Financial Assets (NFA):

NFA = FA − FL

NFA is often a negative number and is therefore called a Net Financial Obligation (NFO). Icelandair however has a rather large cash position on its balance sheet, making its ﬁnancial assets larger than its ﬁnancial obligations and therefore has NFA instead of NFO. NOA and NFA sum to common shareholders’ equity (Penman, 2013):

CSE = NOA + NFA

Icelandair’s non-controlling interest is treated as a separate line item that reduces equity available to common shareholders. CSE is thus calculated as:

CSE = NOA + NFA − non-controlling interest 6.2 TREND ANALYSIS 35

6.1.3 Reformulation of the Income Statement

The income statement reports proﬁts and losses that net operating assets and net ﬁnancial assets have produced for the year. Like with the balance sheet, the reformulation centers around grouping the items into operating and ﬁnancing categories. Operating income and net ﬁnancial expenses are identiﬁed. The reformulated income statement is on a compre- hensive basis, so it includes all dirty surplus items found in the reformulation of the equity statement (Penman, 2013). Following Christensen and Feltham(2009) all taxes are allocated to operating income, since the tax shield from debt is potentially value creating. The “bot- tom line” in the reformulated income statement shows net operating income after tax and dirty surplus less ﬁnancial expenses after dirty surplus giving comprehensive income. The comprehensive income calculated in the reformulated income statement is the same as from the reformulated equity statement. The reformulated statement separates income coming from interactions with customers from income from other none operating activities, making it possible to calculate residual earnings from the operating component of shareholders’ equity.

6.2 Trend Analysis

Table 6-1 shows the trend analysis for Icelandair’s reformulated income statement. The table has been indexed using 2012 as a base year. The trend analysis reveals relative growth (decline) for each item in the statement over time, giving a picture of how the company’s ﬁnancials have changed through the period. From Table 6-1, we see that operating income has been increasing steadily over the period and although operating expenses have increased, they have done so at a slower rate than the income. The decrease in fuel prices lowers the aviation expense item of the operating expense signiﬁcantly in 2015 (see Section 5.1.2. This has resulted in the operating proﬁt doubling over the period. The trend analysis reviles big swings in the dirty surplus items. Currency translation diﬀerences are very volatile and display no trend in either direction. Icelandair’s currency risk and its strategy towards the risk is analyzed in the section on Economic issues in the PESTEL analysis in Section 5.1.2(Currency risk). The same volatility can be seen with items related to hedging. The dirty surplus items are not signiﬁcant and do not contribute to value creation for Icelandair and therefore their volatility has an insigniﬁcant eﬀect on Icelandair’s long-term value. Comprehensive income displays an upward trend over the 4 years and has increased by a factor of 2,82× from 2012. Table 6-2 uses the same format as described above, now for selected items from Icelandair’s reformulated balance sheet. Operating assets remained steady from 2012 to 2014 and in- creased by 20% in 2015. This increase results from the acquisition of new aircrafts, four Boeing 757, one 767 and three Bombardier Q400. For an airline it is not surprising that oper- ating assets remain the same for a period and then increase in larger chunks. Since aircrafts are very expensive, to get a better deal they are usually purchased in larger quantities each time. Operating liabilities have increased steadily over the period, resulting in stable NOA for the period. Comparing the growth in NOA to the growth in comprehensive income from Table 6-1, we see that comprehensive income out grew NOA for the period and we can expect an upward trend in RNOA in the proﬁtability analysis. NFA have increased signiﬁcantly for the period, this is due to cash and short-term investments increasing and a signiﬁcant reduction of long term loans. As a result, common shareholders’ equity has increased by 54% 36 FINANCIAL ANALYSIS over this four-year period.

Table 6-1: Trend Analysis for the Income Statement. Own creation, data from Icelandair’s Annual Reports.

Income Statement Base Year 2012 2013 2014 2015 Operating income Operating income ...... 898.866 100% 114% 124% 127% Operating expenses ...... 789.220 100% 111% 122% 117% Operating proﬁt ...... 109.646 100% 131% 141% 200% Depreciation and amortisation ...... (58.859) 100% 120% 128% 142% Share of proﬁt (loss) of associates ...... (366) 100% 10% 59% -125% Operating income before tax and dirty surplus . 50.421 100% 145% 156% 269% Taxes reported ...... (13.173) 100% 111% 118% 220% Operating income after tax, before dirty surplus 37.248 100% 157% 176% 286% Currency translation diﬀerences ...... (2.285) 100% -184% 236% 74% Net loss on hedge of investment, net of tax ...... (46) 100% -367% 33% 0% Net investment hedge reclassiﬁed to proﬁt or loss . . . (1.417) 100% 8% -51% 0% Eﬀective portion of changes in fair value (1.673) 100% -74% 1425% 7% of cash ﬂow hedge, net of tax ...... Operating income after tax and dirty surplus ... 31.827 100% 201% 116% 329%

Financial expenses Financial income ...... 17.578 100% 39% 41% 73% Financial costs ...... (10.551) 100% 82% 58% 78% Financial expense after dirty surplus ...... 7.027 100% -27% 16% 66%

Comprehensive Income ...... 38.854 100% 159% 98% 282%

Table 6-2: Trend Analysis of selected Balance Sheet items. Own creation, data from Icelandair’s Annual Reports

Balance Sheet Base Year 2012 2013 2014 2015 Total operating assets ...... 626.412 100% 101% 101% 121% Total operating liabilities . . . . 316.057 100% 115% 134% 142% Net operating assets ...... 310.355 100% 87% 68% 99% Net ﬁnancial assets ...... (14.423) 100% 537% 1066% 1030% Common shareholder’s equity 295.675 100% 117% 123% 154%

6.3 Common Size Analysis

A Common size analysis scales each line item analyzed as a percentage of a selected key item. In Table 6-3 selected items from the income statement and reformulated income statement are shown as a percentage of total operating income. 6.3 COMMON SIZE ANALYSIS 37

Table 6-3: Common Size Analysis for Icelandair, selected items from the Income statement. Own creation, data from Icelandair’s Annual Reports

Income Statement 2012 2013 2014 2015 Total operating assets ...... 100% 100% 100% 100% Transport revenue ...... 81% 80% 80% 82% Salaries and other personnel expenses 23% 23% 25% 25% Aviation expenses ...... 46% 42% 41% 36% Other operating expenses ...... 19% 20% 21% 21% Comprehensive income ...... 4% 6% 3% 10%

Icelandair’s core business is air transportation and from Table 6-3 we see that transport revenue’s proportion of total operating income is constant from 2012 to 2015. Although Icelandair has been expanding its route network, Icelandic tourism has grown considerably in the last few years and other operating revenues has kept up with the growth in transport revenue. Labor costs as a percentage of total operating income have increase slightly for the period. The increase is in line with new pilot and ﬂight attendant contracts in 2014 (see Section 5.1.1(Labor contracts and Unions) and Section 5.1.2(Labor cost)). While the decrease in aviation expenses in 2015 is mostly due to declining oil prices lowering the cost of fuel as discussed in Section 5.1.2(Fuel price). Common size analysis is useful when comparing Icelandair to its selected peer group, as the standardization eliminates the eﬀect of size. Table 6-4 shows a comparison of selected income statement items between Icelandair and its selected peer group. Table 6-4 is illustrated in Figure9 in Appendix B.

Table 6-4: Common size analysis for selected income statement items, peer group compar- ison. Own creation, data from companies Annual Reports

Income Statement Icelandair Airberlin Finnair SAS Norwegian Average Total operating income 100% 100% 100% 100% 100% 100% Transport revenue 82% 90% 100% 99% 99% 94% Other operating revenue 18% 10% 0% 1% 1% 6% Salaries and 25% 24% 15% 15% 14% 19% other personnel expenses Aviation expenses 36% 45% 68% 52% 74% 55% Other operating expenses 21% 24% 8% 9% 18% 16%

Icelandair’s transport revenue percentage of total operating income is 12% less than the average for the peer group. This is to be expected since Icelandair’s tourism and hotel segment is a bigger operating segment than for the other companies in the peer group. Salaries and other personnel expenses are a greater percentage of total operating income than the for all other companies in the peer group, 6% higher on average. As discussed before, strong unions and Icelandic labor law will likely keep this cost above the average for the industry. Icelandair’s aviation expenses are signiﬁcantly lower in relation to total operating income than it is for all other companies in the selected peer group. The companies apply a similar 38 FINANCIAL ANALYSIS strategy when hedging fuel, so it is hard to pinpoint an exact reason for this, whether it is from timing of hedges, age and conditions of ﬂeet or other factors. Whatever the cause, it is unlikely to be sustained in the future.

6.4 Proﬁtability Analysis

Here Icelandair’s proﬁtability is analyzed and compared to the proﬁtability of its selected peer group from Chapter4. The proﬁtability analysis is based on analyzing the drivers of ROCE with the purpose of identifying the source of value creation for the company. Icelandair’s proﬁtability is compared to the peer group over a ﬁve-year period from 2011 to 2015, showing how the company stands against its competitors and in what direction the ratios have been moving in recent years. The proﬁtability analysis conducted here follows a similar process and structure as the DuPont scheme and the approaches described in Penman(2013) and in Nissim and Penman(2001). As before all accounting items are viewed from the common shareholders’ perspective, preferred dividends represent a ﬁnancial expense and preferred stock a ﬁnancial obligation. To keep consistency in the comparison all ﬁgures are based on data gathered from Compustat Capital IQ Global databank (COMPUSTAT). Return on Common Equity is usually calculated as:

Comprehensive income ROCE = Average Common Shareholders0 Equity

This ratio does not reveal much about where proﬁtability or value comes from within the company. To get a better sense of this, the analysis breaks down ROCE to its lower levels. First separating operating and ﬁnancing activities, and analyzing the eﬀects of each part. First level ROCE calculated as:

ROCE = RNOA + [F LEV × (RNOA − NBC)] ,

where RNOA is calculated as the product of Asset Turnover (ATO) and the Proﬁt Mar- gin (PM), representing the operating part of the equation. Financial leverage (FLEV) is cal- culated as Net Financial Obligation (NFO) divided by Common Shareholders’ Equity (CSE). Net Borrowing Cost (NBC) is calculated as the Net Financial Expenses divided by the Net Financial Obligation (NFO). From this we see that ROCE is driven by the return on oper- ations with additional return from the leverage of ﬁnancial activities, as before the focus is on the value creation in the operating part. This leads to the second level break down of the ROCE, where the operating part of the equation is further broken down:

ROCE = [PM × AT O] + [F LEV × (RNOA − NBC)]

An important note is that because of missing inputs in the database and the fact that the database does not allow for clean surplus accounting numbers to be used and therefore not all ratios will be as correct as if they would be calculated from a reformulated ﬁnancial statements. Therefore, the main focus is on how Icelandair’s ratios compare to ratios of the selected peer group. 6.4 PROFITABILITY ANALYSIS 39

6.4.1 Proﬁt Margin

The ﬁrst component of the RNOA is thePM, calculated as Operating Income after tax (OI) divided by Sales. The proﬁt margin measures a company’s ability to turn sales into proﬁts, showing the proﬁtability of each dollar of sales.

OI PM = Sales WhereOI is calculated using an approximation suggested by Nissim and Penman(2001). Since some parts of dirty surplus income are associated with non-controlling interests (minor- ity interests), but COMPUSTAT does not provide the necessary details to adjust the data accordingly. Therefore, operating income will be miss-stated in some cases. The diﬀerence is however expected to be small since non-controlling interest is usually very small (Nissim & Penman, 2001).OI is approximated as:

OI = NFE + CNI + NCI, where NFE is Comprehensive Net ﬁnancial Expence, CNI is Comprehensive Net Income and NCI is Non-Controlling Interest. As discussed in Nissim and Penman(2001),OI can include items not incurred to generate the reported sales, these items are referred to as other items and are excluded from the calculated PM giving a Proﬁt Margin originating from sales called corePM. Other items include: equity share of income in a subsidiary, dividends, gains and losses on equity investments marked to market. For this analysis only the corePM is used as other items are a signiﬁcantly less portion of total revenues for the peer group compared to Icelandair.

14% Icelandair Average 12%

Core PM Core 4%

0% 2011 2012 2013 2014 2015

Figure 6-1: Core Proﬁt Margin for Icelandair and the average core PM from the selected peer group. Own creation, data from (COMPUSTAT, n.d.)

From Figure 6-1, it is clear that Icelandair’s core PM has been consistently higher than the peer group’s, continuously for the last 5 years, and is increasing the margin even further in the last year. From 2011 to 2014 Icelandair maintained aPM between 6% and 8% while the peer group averaged only around 2%. From 2014 Icelandair’s Proﬁt Margin sored to over 12% in 2015 while the peer group averaged just under 3%. On average for the whole period Icelandair outperformed its peer group by a signiﬁcant margin of 6,4%. 40 FINANCIAL ANALYSIS

6.4.2 Asset Turnover

The second component of RNOA is the ATO, calculated as Sales divided by NOA from the previous year. Asset Turnover measures units of sales generated by each unit of NOA, showing NOA’s ability to generate sales:

Salest AT Ot = NOAt−1

An important note is that NOA is calculated using an approximation described by Nissim and Penman(2001), since the database does not allow for clean surplus accounting numbers to be used. NOA is calculated as:

NOAτ = DCLτ + LT Dτ + PSτ − (CSITτ + IAτ ) + CSEτ + NCIτ ,

where DCL is debt in current liabilities, LTD is long-term debt, PS is preferred stock, CSTI is cash and short-term investments, IA is investments and advances-other, CSE is common shareholders’ equity and NCI is Non-controlling interest. The approximation does not result in an identical ratio to the one gotten if ATO was calculated using NOA from the reformulated balance sheet, but should be a very close approximation.

5,0x Icelandair Average

0,0x 2011 2012 2013 2014 2015

Figure 6-2: Asset Turnover of Icelandair and the average for the selected peer group. Own creation, data from (COMPUSTAT, n.d.)

Figure 6-2 shows that only recently has Icelandair’s ATO performance surpassed its peer group average. From the graph, we see that Icelandair has increased the amount of revenue it has created per unit of NOA, from the low of 2,2× in 2012 to 4,7× outperforming the peer group average by 0,8× in 2015. For the whole period, Icelandair has however generated 0,7× less sales per unit of NOA than its peers on average. Two planes were added to Icelandair’s ﬂeet in 2016 and deliveries of the ﬁrst of sixteen planes ordered in 2013 are expected in 2018. The eﬀect this increase in operating assets will have on ATO will depend on future sales growth and will be discussed in the forecast in Section 8.1. 6.4 PROFITABILITY ANALYSIS 41

6.4.3 Return on Net Operating Assets

Return on Net Operating Assets is the product of the Proﬁt Margin and the Asset Turnover, calculated as: RNOA = PM × AT O

The ratio measures the percentage return generated per unit of NOA. From the above analy- sis, it should be expected that Icelandair outperforms its peer group slightly during the start of the period, where ATO was low butPM high, and then increase its lead the closer we get to present, asPM and ATO both increased beyond the peer group average.

70% Icelandair Average 60%

Figure 6-3: RNOA for Icelandair & the average for the selected peer group. Own creation, data from (COMPUSTAT, n.d.)

As expected, Figure 6-3 shows that Icelandair outperforms the peer group by a very signiﬁcant margin in 2015 and has been increasing its lead consistently throughout the period. Current RNOA is close to 50% above the peer group average, and on average for the whole period it is 15% above its peers.

6.4.4 Financial Leverage & Operating Spread

Financial leverage (FLEV) is calculated as Net Financial Obligations divided by Common Shareholders’ Equity:

NFO F LEV = , CSE where NFO are calculated as Financial Obligations (FO) minus Financial Assets (FA). Penman (2013) explains FLEV as the degree to which NOA are ﬁnanced by borrowing with NFO. If NOA are ﬁnanced by NFO rather than equity, the return on equity is aﬀected. If the com- pany earns more on its operating assets than its borrowing cost, then the Financial Leverage generates higher returns for shareholders, but if borrowing costs are higher, the returns will be lower. From Figure 6-4 it is evident that Icelandair operates with a much lower ﬁnancial leverage than its peers. 42 FINANCIAL ANALYSIS

250% Icelandair Average 200%

0% 2011 2012 2013 2014 2015 -50%

Figure 6-4: Financial Leverage of Icelandair & the average for the selected peer group. Own creation, data from (COMPUSTAT, n.d.)

The second half of the ﬁnancial aspect of ROCE is the spread between the return on operations RNOA and NBC, calculated as:

Spread = RNOA − NBC

The spread shows the return to shareholders’ equity created by each unit of debt. Each unit of debt acts as an operating asset and earns the return on Net Operating Assets, Net Borrowing Costs are then subtracted, and what is left can be added to the common shareholders’ equity. Figure 6-5 shows that Icelandair’s spread is signiﬁcantly higher than the peer group average.

60% Icelandair Average 50%

Figure 6-5: Operating Spread (RNOA-NBC) for Icelandair & the average for the selected peer group. Own creation, data from (COMPUSTAT, n.d.) 6.4 PROFITABILITY ANALYSIS 43

6.4.5 Return on Common Equity

ROCE = [PM × AT O] + [F LEV × SP READ] Having analyzed each component of the Return on Common Equity, it is now appropriate to have a look at the aggregate result.

50% Icelandair Average 40%

0% 2011 2012 2013 2014 2015 -10%

Figure 6-6: Return on Common Equity for Icelandair & the average from the selected peer group. Own creation, data from (COMPUSTAT, n.d.)

From Figure 6-6, we see that even though Icelandair’s corePM is signiﬁcantly higher than the peer group’s average and the ATO only slightly below the average, it does not translate to a signiﬁcantly higher ROCE. IncreasingPM and ATO in the latter two years manage to oﬀset the eﬀect created by negative FLEV and increasing Spread and in 2015 Icelandair’s ROCE is within 7% from the peer group average. Over the whole period Icelandair has an average ROCE of 33%, 14% above the peer group average. 44 FINANCIAL ANALYSIS 7| Quantitative Industry Analysis

Section 3.4 gave an overview of the airline industry and in Chapter5 forces aﬀecting the industry were examined. In this chapter, a more empirical or quantitative analysis of the airline industry will be performed. The purpose is to see how diﬀerent value drivers of ReOI have evolved over a large sample of airlines for the past 25 years. This analysis is a bridge between the previous sections of the thesis, especially the proﬁtability analysis in Section 6.4, and the forecast in Chapter8. Providing a historical benchmark for the value drivers and showing how current drivers are likely to behave in the future, whether they are more likely to stay at current levels or revert to the industry’s long-run level. The quantitative industry analysis is split up into two sections. First an analysis of how diﬀerent ReOI value drivers have evolved from 1991- 2015 for the global airline industry. This analysis follows the method described by Nissim and Penman(2001) for constructing fade diagrams. Fade diagrams are good to visualize trends in the industry as they give a picture of historical evolution for the value drivers within the industry. The second part of the analysis focuses on quantifying the fade diagram analysis. That is, quantifying how persistent or mean reverting each value driver is and what it’s typical “long-run” or “steady state” level is likely to be. A ﬁrst-order autoregression with mean reversion to a constant long-run level is used. Being able to quantify the persistency in the value drivers and estimate it’s long-run level is particularly useful for forecasting as history shows that there is a tendency for the value drivers to revert to their typical values over time.

7.1 Fade Diagrams

7.1.1 Methodology and data

The fade diagrams are constructed using the procedures described in Nissim and Penman (2001) paper “Ratio Analysis and Equity Valuation: From Research to Practice”. The fade diagrams show how selected ratios, identiﬁed as value drivers of ReOI in the proﬁtability analysis, have evolved over a selected period for an industry or group of companies. First step in the analysis is selecting companies to represent the industry and gathering relevant data. As in their paper, I have used data from COMPUSTAT for companies with SIC code1 4512 (Airlines), extracting accounting numbers from 1989 to 2015 for 117 diﬀerent airlines. For this quantitative industry analysis ﬁve key value drivers of ReOI have been chosen; Asset Turnover (ATO), Sales Growth (SG), Proﬁt Margin (PM), Net Operating Asset growth (NOA Growth) and Return on Net Operating Assets (RNOA). Using the data available on COMPUSTAT the value drivers are calculated as:

Revenueτ AT Oτ = , NOAτ−1 Revenueτ − Revenueτ−1 SGτ = , Revenueτ−1 Operating Incomeτ PMτ = , Revenueτ

1SIC code is a system for classifying Industries using a four digit code. 46 QUANTITATIVE INDUSTRY ANALYSIS

NOAτ NOA Growthτ = − 1 , NOAτ−1 Operating Incomeτ RNOAτ = . NOAτ−1 The construction of the fade diagrams is done in the following steps:

• First the data is sorted, showing each companies value driver for each year.

• For each year the range of value drivers are broken down into quintile and for each year companies are ranked from 1 to 5 based on where their value driver falls within that years range. The lowest 20% receive a ranking of 1, the next 20% 2, and so on and so forth. The rankings represent what portfolio the company will be grouped in.

• Portfolios are constructed ﬁve times during the period, in 1991, 1996, 2001, 2006, 2011. The portfolios are followed for the next ﬁve years following the ranking year and for each year a median value for each portfolio is calculated. At the end of the ﬁve years the ranking is done again for the next ﬁve years, and so on until the ﬁnal portfolio formation in 2011.

• At the end of the period (2015) the averages of the median values for each portfolio is calculated for the portfolio formation year and the following ﬁve years across the diﬀerent time periods. Taking the average across the time periods reduces the eﬀect of the business cycle.

• The fade diagrams are then produced by graphing the averages for each portfolio, show- ing the evolution of the value drivers for ﬁve years during the period from 1991 to 2015.

It is important to keep in mind that the construction of the fade diagrams does conjure up a few issues that might distort the results. For example, company weights are not relative to size but instead every company is equally weighted. There is potential for the data to represent signiﬁcant survivor ship bias, as defaulting and low proﬁting airlines drop out. A change in the currency of accounting numbers is another thing to keep in mind as many European airlines switched to the Euro during the period and a switch in reporting currency can have very signiﬁcant impact on the ratios calculated. Unlike the other problems, the currency reporting problem is easily ﬁxable by using historical fx rates to adjust the numbers so each company’s accounting data is reported in the same currency through the whole period. 7.1 FADE DIAGRAMS 47

7.1.2 Asset Turnover

As discussed in the proﬁtability analysis in Section 6.4, Asset Turnover measures a company’s ability to generate sales form its Net Operating Assets.

10,0x 9,0x 8,0x 7,0x 6,0x 5,0x

ATO 4,0x 3,0x 2,0x 1,0x 0,0x t t+1 t+2 t+3 t+4 Year Relative to Portfolio Formation Year

Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4 Portfolio 5

Figure 7-1: Fade Diagram, Asset Turnover for the Airline industry. Own creation, data from (COMPUSTAT, n.d.)

Figure 7-1 shows a very high persistency in ATO for the airline industry. For portfolios 1 through 4, ATO is almost constant for the whole period. Portfolio 5 shows a signiﬁcant initial mean reversion but settles on level well above the next highest Portfolio 4. It is possible that Portfolio 5 might include diﬀerent type of airlines (helicopter service for instance), or diﬀerences in business models and could therefore be seen as an outlier for the industry. That being said, there are a lot of well-known airlines in the 5th and top portfolio. It seems therefore that ATO levels are very persistent and even high level are relatively sustainable. Judging from Figure 7-1, ATO is expected to have high persistence coeﬃcient ω in the autoregression.

7.1.3 Proﬁt Margin

Proﬁt Margin measures a company’s operational eﬃciency, showing the percentage of sales turning into proﬁt. Figure 7-2 shows less persistency than for ATO as the portfolios seem to slowly converge towards a mean. Portfolio 5 is able to maintain its superiorPM throughout the period. A highPM with relatively low mean reversion, indicates that some airlines are able to establish a competitive advantage that can be sustained. But since the data analyzed is on airlines globally, the diﬀerences inPM can be due to many diﬀerent reasons, for example: diﬀerences in business models, the market the company operates in and the level of wages it is required to pay. 48 QUANTITATIVE INDUSTRY ANALYSIS

0% t t+1 t+2 t+3 t+4 Year Relative to Portfolio Formation Year

Figure 7-2: Fade Diagram, Proﬁt Margin for the Airline industry. Own Creation, data from (COMPUSTAT, n.d.)

7.1.4 Sales Growth

Sales Growth is simply a measurement of how sales grow from one year to the next and is usually highly inﬂuenced by the state of the economy.

-10% t t+1 t+2 t+3 t+4 Year Relative to Portfolio Formation Year

Figure 7-3: Fade Diagram, Sales Growth for the Airline industry. Own creation, data from (COMPUSTAT, n.d.) 7.1 FADE DIAGRAMS 49

It is evident from Figure 7-3, thatSG shows much less persistency than the previous value drivers and there is a clear mean reversion in SG. This is expected as the airline industry is highly competitive and thus sustaining a highSG compared to the rest of the industry unlikely. A low persistence coeﬃcient ω is expected in the autoregression.

7.1.5 Net Operating Asset Growth

As withSG, Net Operating Assets Growth is simply a measurement of the growth in NOA from one year to the next. LikeSG, NOA growth is highly inﬂuenced by macro-economic circumstances.

NOA GrowthNOA 0%

-40% t t+1 t+2 t+3 t+4 Year Relative to Portfolio Formation Year

Figure 7-4: Fade Diagram, Net Operating Asset Growth for the Airline industry. Own creation, data from (COMPUSTAT, n.d.)

Figure 7-4 conﬁrms a high mean reversion in NOA growth and a very low persistency is expected in the autoregression.

7.1.6 Return on Net Operating Assets

Return on Net Operating Assets measures the percentage of operating returns generated by one unit of net operating assets. Figure 7-5 shows a steady conversion towards a long-run level for RNOA. The mean reversion is not as pronounced as for NOA growth but does suggest that airlines will receive similar returns on NOA in the long-run. 50 QUANTITATIVE INDUSTRY ANALYSIS

Figure 7-5: Fade Diagram, Return on Net Operating Asset Growth for the Airline industry. Own Creation, data from (COMPUSTAT, n.d.)

7.1.7 Market-to-book premium

Even though not a value driver of ReOI and will not be used to forecast future ReOI, a long-run estimate of the market-to-book ratio is need. As discussed in Chapter2(Valuation Methodology) and further seen in Chapter 10(Valuation), a long-run value of the market-to-book ratio is needed as an input in calculating continuation value in one method chosen. The ratio is calculated as the Enterprise Value (EV) divided by NOA.

EVτ MBτ = NOAτ

EV/NOA 1,5x

0,0x t t+1 t+2 t+3 t+4 Year Relative to Portfolio Formation Year

Figure 7-6: Fade Diagram, Market-to-book ratio for the Airline industry. Own creation, data from (COMPUSTAT, n.d.; Bloomberg, n.d.-d) 7.2 TIME-SERIES ANALYSIS 51

TheEV values are gathered from Bloomberg(n.d.-d) for the same sample of companies as for previous quantitative analysis. Figure 7-6 shows an early mean reversion for the highest scoring portfolio, but over all a high persistency and judging by the graph a long term mean of EV/NOA seems to be between 1× and 1,5×.

7.2 Time-Series Analysis

From the fade diagrams, the trend of the airline industry’s key ReOI value drivers have been analyzed. This section serves as an extension to that. Here a time series analysis will be performed to determine and quantify how quickly each value driver is reverting to its long- run level, as well as estimating the long-run level. This information will play a crucial role in forecasting estimations in Chapter8(Forecasting).

7.2.1 Methodology

The time-series analysis is performed using a ﬁrst-order autoregression with mean-reversion to a constant long-run level. This process captures the persistency of the value drivers and their long-run levels. To ensure consistency, the same data for the same 25-year period used in the fade diagrams is used for the autoregression process. First-order autoregression model:

xτ − a = ω(xτ−1 − a) + τ ,

where xτ is the ratio or value driver being analyzed, a is the long-run level, ω ∈ (−1, 1) is the 2 persistence coeﬃcient of the deviation from the long-run level for the driver, and τ are IID normally distributed innovations with mean zero and variance σ2 (Christensen, 2015a). The process starts by setting up the data and choosing initial values for a and ω. Next residuals for each year and ﬁrm are calculated as:

uiτ (¯a, ω¯) = (xiτ − a¯) − ω¯(xi,τ−1 − a¯)

The use of median values in the fade diagram limited the eﬀect abnormal outliers and errors in the data had, this same problem is solved here by excluding the top and bottom 2,5% of the distribution of residuals. Then the sum of squared residuals (SSR) is determined:

I t X X 2 SSR(¯a, ω¯) = (uiτ (¯a, ω¯)) i=1 τ=t−T Finally, a and ω are estimated for each value driver in each group by minimizing SSR.A high persistence coeﬃcient ω indicates that the value driver being tested will revert slowly towards the long-run mean.

7.2.2 Autoregression estimates

Since the main beneﬁt of the time-series analysis is to aid in the process of forecasting value drivers for Icelandair, the regression was run on more than just the industry as a whole like

2Independent and identically distributed random variables 52 QUANTITATIVE INDUSTRY ANALYSIS in the fade diagram analysis. In addition to the whole industry, the data is also sorted to group the selected peer group from Chapter4, both including and excluding Icelandair from the selection. After persistency coeﬃcient and long-run levels have been estimated for the three groups a simple average is calculated. This will help with the estimation of likely future values for Icelandair’s value drivers. Estimates gathered in this analysis will provide the base for forecasting Icelandair’s key ReOI value drivers in the fade period. Table 7-1 shows a summary of the autregression estimates for each group and value driver.

Table 7-1: Autoregression estimates on value drivers and EV/NOA. Own creation, data from (COMPUSTAT, n.d.; Bloomberg, n.d.-d)

Peer Group including Icelandair (n = 89) ATO PM SG NOA g. RNOA EV/NOA Mean (a) 3,1x 4% 7% 7% 11% 1,5x Persistence (w) 0,62 0,56 0,50 0,40 0,40 0,88 RSQ 0,71 0,31 0,28 0,12 0,34 0,55

Peer Group excluding Icelandair (n = 79) ATO PM SG NOA g. RNOA EV/NOA Mean (a) 4,1x 3% 7% 7% 9% 1,1x Persistence (w) 0,75 0,61 0,52 0,44 0,61 0,68 RSQ 0,56 0,40 0,31 0,15 0,63 0,41

Industry (n = 1598) ATO PM SG NOA g. RNOA EV/NOA Mean (a) 2,2x 6% 12% 10% 12% 1,6x Persistence (w) 0,75 0,76 0,25 0,08 0,45 0,58 RSQ 0,61 0,60 0,06 0,01 0,21 0,35

Average ATO PM SG NOA g. RNOA EV/NOA Mean (a) 3,1x 4% 8% 8% 11% 1,4x Persistence (w) 0,70 0,65 0,42 0,31 0,49 0,71 RSQ 0,63 0,44 0,22 0,09 0,40 0,43

Asset Turnover

For ATO the autoregression estimates a long-run level in the range from 2,2× to 4,1×, giving an average of 3,1× across the three groups. The peer group excluding Icelandair has a signiﬁcantly higher long-term ATO level and a higher persistence coeﬃcient than the peer group including Icelandair. This will be taken into account during the forecast, as Icelandair seems to be closer to the industry’s long-run ATO level than to the selected peers. Persistence is estimated to be in the range from 0,62 to 0,75 with an average of 0,70. As expected the persistency is high for ATO and therefore companies seem able to sustain their high (or low) 7.2 TIME-SERIES ANALYSIS 53

ATO beyond the short term. See Figure 10 in Appendix C for visualization.

Proﬁt Margin

The regression estimates a long-termPM range from 3,1% to 6,2%, giving an average of 4,3% across the groups. The persistency is in line with expectations from the fade diagrams, lower than for ATO but still relatively high, ranging from 0,56 to 0,76. As expected from the proﬁtability analysis Section 6.4 the peer group including Icelandair has a higher long-term PM, but still lower than the industry’s. The high persistency indicates that superiorPM are possible to sustain. See Figure 11 in Appendix C for visualization.

Sales Growth

SG have an estimated long-run level ranging from 6,8% to 11,6% with an average of 8,4%. This is a wide range and is highest for the industry as a whole but the same long-term level is estimated for the peer group including and excluding Icelandair. As noted in the fade diagram SG is subject to a higher degree of mean-reversion than the two previous value drivers. SG’s estimated persistency ranges from 0,25 to 0,52. The persistency is higher than expected, especially for the peer group samples where persistency is close toPM levels. See Figure 12 in Appendix C for visualization.

NOA growth is estimated to have long-run levels ranging from 6,8% to 9,5%, averaging 7,7% across samples. From the fade diagram analysis of the industry where high mean-reversion was clear, a very low persistency coeﬃcient ω was expected. The estimated persistency for the industry was as expected very low, only 0,08, but for the peer group it was however relatively high 0,4 including Icelandair and 0,44 excluding Icelandair. For an industry like the airline industry it is unlikely that certain airlines will be able to sustain a growth in NOA and keep proﬁts above the industry’s long-term level. See Figure 13 in Appendix C for visualization.

RNOA has an estimated long-run level ranging from 9,1% to 12,2%, averaging at 10,9%. As expected from the proﬁtability analysis in Section 6.4, the peer group including Icelandair has noticeably higher RNOA than the peer group excluding it, but still lower than the industry as a whole. Again the diﬀerence may lie in diﬀerent business models or strategy. See Figure 14 in Appendix C for visualization.

EV/NOA (Market-to-book)

The autoregression reveals a long-term mean for EV/NOA at 1,5× for the peer group including Iceland air and a slightly higher 1,6× value for the industry. The ratio seems very persistent, with a persistency coeﬃcient of 0,88 for the peer group including Icelandair and 0,71 for the industry. See Figure 15 in Appendix C for visualization. 54 QUANTITATIVE INDUSTRY ANALYSIS 8| Forecasting

Valuing Icelandair using the ReOI model requires an estimation of future ReOI. In this chap- ter the future value drivers of ReOI will be forecasted. Forecasting involves a great deal of speculation as the future is uncertain and as can be seen in Section 3.4(Airline Industry) especially uncertain for airlines. The quantitative industry analysis in the previous chap- ter serves as the basis for the forecast along with information gathered from the ﬁnancial statement analysis and the strategic analysis. For this forecast the forecasting period is split into two sections: a ﬁve-year explicit period from 2016 to 2020 and a fade period where value drivers reach their long-term level. In each section the future rate of the three value drivers Asset Turnover (ATO), Proﬁt Margin (PM) and Sales Growth (SG) will be estimated.

8.1 Explicit Period (2016-2020)

The explicit forecast period is a short-term period spanning from 2016 to 2020. For this period the forecast is based on a combination of information gathered from the quantitative industry analysis, the strategic and ﬁnancial statement analysis, as well as industry and economic indicators.

8.1.1 Sales Growth

SG is the most important ReOI value driver to forecast for airlines. As discussed in Section 3.1 Icelandair’s main operation is air transportation and there of passenger transportation is most important. Therefore, growth in sales generated by passengers for the next ﬁve years is the focus of this section.

900.000 25% Passenger Revenue Growth 800.000

700.000 20%

600.000 15% 500.000

400.000 10% Growth 300.000

Passenger Passenger revenue 200.000 5% 100.000

0 0% 2011 2012 2013 2014 2015

Figure 8-1: Passenger Revenue and growth from 2011 to 2015. Own creation, data from Icelandair’s Annual Reports 56 FORECASTING

Icelandair’s operating income has grown very rapidly since the restructuring in 2010-2011 and the driving force has been the increase in passenger revenue. Since 2011 revenues stemming from passengers has increased by 105% or on average 16% annually (Icelandair Group hf, 2016b). However as is clear from Figure 8-1, growth in passenger revenue has come to a sudden halt. From a 16% growth between 2013 and 2014 to only 5% growth from 2014 and 2015. There are diﬀerent possible reasons for this. One is that Icelandair had a great year in terms of utility, setting a new personal record in load factor every month during 2015. The reason for the slowdown in sales growth could be that Icelandair had reached its ﬂeet capacity. With the addition of the two 767-300 (262 seat) aircrafts in 2016 and the ﬁrst of 16 new 737’s coming in at 2018 (Icelandair Group hf, 2016b), Icelandair will increase its supply and (if the demand is there) sales should increase again. Another scenario is that there might be a shift in the economy in Icelandair’s main markets. After a period of growth in GDP, Iceland, the Euro area, and the world saw a decline in GDP and north America’s growth declined. As established in the analysis in Section 5.1.2(Economic issues), number of transported passengers is heavily correlated with GDP.

Nominal GDP (normalized) 95

90 2010 2011 2012 2013 2014 2015

Euro area Iceland World North America

Figure 8-2: GDP Normalized data. Own creation, data from (The World Bank, 2015)

Figure 8-2 shows the 2015 decline in GDP for Iceland, the Euro area, the world and though N-America’s GDP did not decline like the rest, it’s growth slowed down. One year of declining GDP certainly does not mean that these areas are heading into a recession, but given the recent instability in Europe it is worth taking into consideration. Icelandair’s ﬂight schedule assumes a 24% increase in the number of Available Seat Kilometers (ASK) for 2016 (see Section 5.4.1 for analysis). With four new destinations (43 destinations in 2016), Icelandair further estimates a 20% increase in passengers carried, or 3,7 million passengers in 2016, compared to 3,1 million in 2015. This growth is estimated based on the addition to the ﬂeet while keeping same high load factor (see Section 5.4.3)(Icelandair Group hf, 2016b). Iceland’s tourism has grown close to 130% since 2011 and has been increasing every year (see Figure 5-3)(Ferdamalastofnun, 2015). If the trend continuous like it has for the next ﬁve years, the number of international tourists in Iceland will reach well over two million (1,3 million in 2015). Even a slowdown to a modest 10% increase per year will reach over two 8.1 EXPLICIT PERIOD (2016-2020) 57

4,0 25% Total number of passengers Growth 3,5

(Millions) 20% 3,0

Passengers 1,5

- 0% 2010 2011 2012 2013 2014 2015 E2016

Figure 8-3: Passengers carried and growth. 2016 estimated by Icelandair. Own creation, data from Icelandair’s Annual Reports

million visitors in 2020. As discussed in Section 3.1.1(Route Network), Icelandair’s route network is split into three segments: VIA, TO and FROM. The VIA market is the biggest 49% of passengers in 2015, TO is second with 36%, and FROM is the smallest with 16%. With such a high percentage of Icelandair’s passengers traveling to Iceland and the increase in passengers stopping in Iceland for a layover these number reinforces the estimation of increase in sales. As seen in the quantitative industry analysis (Chapter7),SG is quite mean reverting. The autoregression revealed a low persistency coeﬃcient of 0,25 with a long-term mean of around 12% for the industry as a whole. The peer group however showed a lower long-term level of 7% with a persistency of 0,5. Taking this inconsideration with the analysis given above, Icelandair’s sales are expected to increase to 10% for 2016 and grow additional 1,11% during the explicit period reaching 15% in 2020 where the fade period starts.

8.1.2 Proﬁt Margin

During the quantitative industry analysis proﬁt margins exhibited high persistency. The air- line industry had a long-term mean of 6,2% with persistency of 0,76 and the fade diagram indicated that companies within diﬀerent portfolios maintained their margins quit well. Dur- ing the period from 2011 to 2014 Icelandair had a steady proﬁt margin ranging between 6% and 8%, before a rapid increase to above 11% in 2015. Icelandair’s PM is well above its peer group average for the same period as well as the long-term level seen in the autoregression for the peer group excluding Icelandair. The sharp increase inPM from 2014’s 7,4% to 2015’s 11,4%, is largely due to the decline in oil prices during 2015 (see Section 5.1.2(Fuel price)). As oil prices have begun to rise from the bottom in January 2016 (see Figure 5-4) they are expected to continue to rise, but without a sharp increase. Considering these factors, it seems unlikely that Icelandair will continue to grow its margins and more likely that they will de- crease towards the previous range between 6 and 8%, which is close to the industry’s mean. 58 FORECASTING

During the explicit forecast period Icelandair’sPM is estimated to decrease by 1% per year, from 11,4% in 2015 to 6,44% in 2020.

8.1.3 Asset Turnover

ATO showed a very high persistence of 0,7 and a long-run level of 2,2× for the industry in the quantitative industry analysis. While it was seen in Section 6.4(Proﬁtability Analysis) that Icelandair only outperformed its peer group during last year, it has been well above the industry’s long-run mean in the last three years, with on average 3,0× ATO from 2011 to 2015. As discussed before, the addition to the ﬂeet is gradual, and if aircraft utilization eﬃciency remains around the same level as it currently is, ATO is likely to stay at close to its current level. ATO is therefore expected to remain constant at 4,0× throughout the explicit period.

8.2 Fade Period

At the end of the ﬁve-year explicit period a longer term period starts, where the value drivers fade towards their long-term levels. This fade period derives its values from the quantitative industry analysis. The value driver approaches the selected level of a (calculated in the autocorrelation) with the persistency of ω, both of whom are based on the the analysis in Chapter7. The expected level of a value driver at a future date τ is calculated as:

τ−t E[xτ |xt] = a + ω (xt − a)

Here xt will take the form of each of the three value drivers, ATO,PM andSG at the last year of the explicit period.

Historical Explicit Fade 18% 5,0x PMPM SGSG ATOATO 16% 4,5x

14% 4,0x 3,5x 12% 3,0x 10% 2,5x 8% ATO PM & SG & PM 2,0x 6% 1,5x

Figure 8-4: Forecast period for the ReOI value drivers: PM, SG and ATO. 8.2 FADE PERIOD 59

8.2.1 Sales Growth

As can be seen in Figure 8-4,SG is entering the fade period at a very high level of 15%, this is almost certainly not a sustainable long-term level. From the quantitative industry analysis Sales Growth was estimated to have a long-run level ranging from 7-12%. The lower end of the range still seems rather high for a long-term growth rate, as OECD forecasts a nominal GDP growth of 4% annually for OECD countries and 2,8% for the Euro area (OECD, n.d.) and the Icelandic central bank’s inﬂation target is 2,5% (Sedlabanki Islands, 2016). A long- term level of 5% seems more realistic and will converge with a persistency of 0,42. The peer group exhibited a higher persistency than the market and an even higher one when Icelandair was excluded, therefore an average of the three persistency coeﬃcients is used here, giving a persistency of 0,42. It is clear form Figure 8-4 thatSG converges very quickly and has almost reached its long-run level in ﬁve years.

8.2.2 Proﬁt Margin

Proﬁt margins displayed a high persistency in the industry analysis, but varied a lot depending on the sample. The industry as a whole showed a high long-term level of 6,25% with a persistency of 0,76, while the peer group including Icelandair had a more modest 3,6% long- termPM with a persistence of 0,56. An average of the long-termPM levels between the groups is used rounded to the next half, giving a fade rate forPM of 4,5%. This seems reasonable as a long-term level given both current proﬁt margins and the industry’s estimate. The quantitative industry analysis revealed the high persistency ofPM in the airline industry and that airlines were able to sustain their level; therefore, the persistence level of the industry will be used, 0,76.

8.2.3 Asset Turnover

Like thePM, ATO showed signiﬁcant persistency in the quantitative industry analysis. The industry had somewhat lower long-term level than the peer group excluding Icelandair and the peer group including Icelandair was right in the middle of the two. The peer group including Icelandair seems to give a good estimate of Icelandair’s long-term ATO level, giving a long-term level of 3,1× with a persistence of 0,7. 60 FORECASTING 9| Estimation of Icelandair’s Cost of Capital

As discussed in Chapter2(Valuation Methodology), an estimation of Icelandair’s cost of capital is required to discount future ReOI and arrive at an estimation of the value on April 8th 2016. The term structure of cost of capital is calculated using a modiﬁcation of the CAPM, combining an estimation of the term structure of risk free interest rates with Icelandair’s risk premium. The risk premium is kept constant for the period while the term structure of interest rate is variable (Christensen, 2015c; Brennan & Xia, 2003) and the term-structure of Icelandair’s cost of capital is deﬁned as:

F Rtτ = (1 + ιtτ )(1 + RPF )

Where ιtτ is the discretely compounded zero-coupon rate at time t with maturity at τ and a RPF risk premium for Icelandair. Using the CAPM, the market risk is measured with a beta coeﬃcient, which is then multiplied by the equity risk premium, giving a total risk premium for Icelandair (Damodaran, 2015). In this chapters each of these factors making up the cost of capital is estimated.

9.1 Estimating the Term Structure of Interest Rates

In this section the term structure of interest rates used in calculations of Icelandair’s cost of capital is estimated. The purpose is to acquire appropriate interest rates for each date in time, giving a more accurate result than using a constant risk free rate throughout the period. Here the Nelson-Siegel model is used to approximate the term structure at any point in time, based on outstanding Icelandic government bonds. The model is globally used by central banks and ﬁnancial institutions.

9.1.1 Bond Pricing

The Fundamental Theorem of Asset Pricing implies that in a non-arbitrage bond market, there exist implied zero-bond prices Zt(τ) such that (Bliss, 1996; Christensen, 2015d):

N X Bit = ciτn Zt(τn), i = 1, 2, ..., I n=1 This is a system of I linear equations with N unknown zero-coupon bond prices. Where Bit is the listed price of the bond plus any accrued interest, ciτ is cash ﬂows at dates τ = τ1, τ2, . . . , τN for the chosen bond sample. If N = I, that is if the number of cash ﬂow dates is equal to the number of bonds, solving the linear equation will yield a solution. However, as is usually the case in practice, I > N and therefore an exact pricing relation is exchanged for an inexact relation (Bliss, 1996; Christensen, 2015d):

N X Bit = ciτn Zt(τn) + it, i = 1, 2, ..., I n=1 62 ESTIMATION OF ICELANDAIR’S COST OF CAPITAL

Here a “noise term” has been added to the equation allowing for an estimation of the pa- rameters Zt in a regression. By assuming a parametric functional form for the zero-coupon T h. bond prices the distance between the theoretical prices (Bit ) and the observed market prices M (Bit ) is then minimized by varying the parameters (Christensen, 2015d). For this the stan- dard version of the Nelson Siegel model is used.

The Nelson Siegel Model

To estimate the yield curve, the model proposed by Nelson and Siegel(1987) in their paper "Parsimonious Modeling of Yield Curves", commonly referred to as the Nelson Siegel (NS) model, is used.

Nelson and Siegel(1987) describe the forward rate at maturity τ, ft,τ as the solution to a second-order diﬀerential equation with equal roots: τ − t f = θ + θ e−(τ−t)/λ + θ e−(τ−t)/λ tτ 0 1 2 λ where θ0, θ1, θ2 and λ are constants parameters and (τ − t) is the time to maturity. The yield curve is then given by:

1 − e−(τ−t)/λ gNS(t, τ; θ) = θ + (θ + θ ) − θ e−(τ−t)/λ 0 1 2 (τ − t)/λ 2

where θ0 represents the long-term rate, (θ1 + θ2) is the approximated short term rate, θ2 aﬀects the concavity (convexity) of the term structure and λ gives the location of the hump (Benninga, 2014). The yield curve is then ﬁtted to the market data by changing the parameters so that the distance between the prices estimated byNS and the market prices is minimized.

As mentioned in Section 3.3, Icelandair’s shareholders are almost entirely Icelandic and there- fore the Icelandic government bonds are chosen as the “risk-free” rate. The capital controls also constrict many investors, especially individual investors, to consider the Icelandic govern- ment bonds as their risk-free alternative. The Icelandic bond market is very small compared to even other Nordic nations and outstanding government bonds at the date of valuation (8.4.2016) are seven non-indexed long-term government bonds and two short term govern- ment bills. The time to maturity on these bonds ranges from 0,35 years to 14,8 years. The yield curve is estimated with the method described above using the Icelandic government bonds and bills, but with so few bonds the lack of available data can impact the precision of the estimation of the yield curve. As can be seen from Figure 9-1, the model prices still ﬁt relatively well with the market prices. The price errors seem to be evenly and randomly distributed, going from positive to negative, this can be seen in the error plot in Appendix D. Table 9-1 shows the estimated parameters for theNS model of the Icelandic yield curve. 9.1 ESTIMATING THE TERM STRUCTURE OF INTEREST RATES 63

1,4 Market prices NS prices 1,3 1,2 1,1 1 0,9

Prices 0,8 0,7 0,6 0,5 0 2 4 6 8 10 12 14 16 Years to maturity

Figure 9-1: Nelson & Siegel model prices ﬁtted to market prices. Own creation, Market price from (Sedlabanki Islands, n.d.).

Table 9-1: Nelson-Siegel model parameter estimation.

Parameter θ0 θ1 θ2 λ λ0 + λ1 SSR Estimate 0,069879 0,001689 -0,03638 6,291726 0,071568 0,002254

8,0% Forward rate ZC interest rates 7,5%

5,0% 0 5 10 15 20 25 30 35 40 Years to maturity

Figure 9-2: Risk free zero coupon yield curve and forward rates, discretely compounded.

Figure 9-2, shows the discretely compounded zero-coupon yields along with the discretely compounded forward rates. 64 ESTIMATION OF ICELANDAIR’S COST OF CAPITAL

Normally a yield curve is upwards sloping, as it is for most countries. However, Iceland is not like most countries and at the date of analysis the Icelandic yield curve is rather negative and ﬂat with yields around 6,5%. Icelandic non inﬂation indexed bills and bonds have yields ranging from the short term RIKV bill maturing in august 2016 with a yield of 7,4% down to around 6% for the bonds with a longer maturity. These yields are very high compared to the current yields in both Scandinavia and other established markets, but Iceland’s inﬂation is much higher than for those countries, estimated at around 3,5% for the year 2016 (Islandsbanki, 2014).

9.2 Estimation of Icelandair’s Beta

A ﬁrm speciﬁc beta is the aggregate beta value of the ﬁrm’s equity beta and debt beta, weighted by the capital structure of the company.

E D βF irm = βEquity × + βDebt × EV EV

In this valuation βDebt is assumed to be zero and therefore the focus is on the equity beta. The assumption is that the debt carries such a low market risk that it will be close to zero and have little impact on the cost of capital.

9.2.1 Equity Beta

A ﬁrm’s equity beta is usually measured as the slope of a time-series regression of its equity returns on the returns of a stock index (Christensen, 2015c).

F irm Covτ (REτ ,RMτ ) βτ = V arτ (RMτ )

Where REτ is the return on the ﬁrm’s stock returns and RMτ are returns on the index used as a proxy for market returns. The beta is a measurement of how volatile the ﬁrm is compared to the market, therefore measuring macroeconomic risk exposure. For Icelandair, weekly returns are regressed against the icelandic index OMX ICE8 for a period of the last ﬁve years. Table 9-2 shows the results from the regression. For this period Icelandair’s equity beta is 1,0855.

Table 9-2: Beta estimation using ﬁve year weekly returns. Own creation, data from (Datastream, n.d.).

Market Proxy β α R2 OMX ICE8 1,0855 0,00452 0,383714

In order to get a ﬁrm speciﬁc beta value, the impact from debt needs to be removed. Therefore, the unlevered beta is calculated as: E βU = βL × = 1, 0855 × 0, 83 EV 9.2 ESTIMATION OF ICELANDAIR’S BETA 65

This method gives a ﬁrm speciﬁc beta for Icelandair equal to 0,9. However, this beta is subject to a number of diﬀerent problems. The ﬁrst one is that the regressed equity beta will depend on the time horizon and the return intervals selected for the regression and this can have a signiﬁcant eﬀect on the beta estimation. Another more signiﬁcant problem is that the Icelandic market is small and illiquid relative to more established markets and Icelandair’s weight is signiﬁcant in the OMX ICE8 index. This can indicate that the result is a biased estimate of the equity beta, as Icelandair’s stock returns are almost regressed against them selves.

9.2.2 Bottom-up Beta

To combat the problem with the regressed equity beta, the beta coeﬃcient is also estimated using Damodaran’s bottom-up beta approach (Damodaran, n.d.-c). This is a 4 step approach to estimating a company’s beta, described by Damodaran as:

1. Find out the business that the ﬁrm operates in.

2. Find unlevered betas of other ﬁrms in the same industry.

3. Calculate a weighted average (by sales or operating income) of these unlevered betas.

4. Lever up the betas using the ﬁrm’s debt to equity ratio.

The reason that the bottom up beta can give a more accurate estimate is the law of large numbers, meaning that an average of many beta estimates is more likely to yield a better estimate than a single regression. The ﬁrst step is to evaluate the business that Icelandair operates in. Icelandair is an airline and as discussed in Section 3.4 the airline industry has an elastic demand. Industries with elastic demands will generally have a higher beta than those with inelastic demands. Airlines have high ﬁxed costs, and high ﬁxed costs have a multiplying eﬀect on the business and therefore increasing its variance. Airlines are therefore expected to have a mid-to-high beta value. For the airline industry’s betas, Damodaran’s data from 5th January 2016 is used. Damodaran’s estimations can be seen in Table 9-3.

Table 9-3: Damodaran Air Transport beta estimation - average values. Own creation, adopted from (Damodaran, n.d.-b, n.d.-a).

Region # Firms av. Unlevered beta av. Levered beta Air Transport Global 160 0,61 0,96 Air Transport US 20 0,81 1,27

There is a large diﬀerence in the sample size between the Global and US airlines, and the beta values also show a signiﬁcant diﬀerence. 66 ESTIMATION OF ICELANDAIR’S COST OF CAPITAL

9.2.3 Icelandair’s Equity Beta

Icelandair’s leveraged beta of 1,0855 falls between the two averages of industry levered betas from Table 9-3. However, its unleveraged beta of 0,9 is higher than the industries average. It seems most likely that the best estimate of Icelandair’s unlevered beta value lies somewhere in the middle, therefore a simple average of the three unlevered betas is taken and Icelandair’s beta is estimated as 0,775 1.

9.3 Equity Risk Premium

Equity risk premium is a central component of risk and return models in ﬁnance and as seen earlier is a key input in estimating cost of capital. The equity risk premium measures the required return investors require to be compensated for the risk they take on. The equity risk premium is a market wide number that eﬀects expected returns on all risky investments in the market it is estimated for. Equity risk premium is determined mainly by: investor risk aversion and consumption preferences, macro-economic risk, quantity and quality of information available to investors, liquidity in the market, catastrophic risk, government policy and the irrationality of investors. It is important to note the choice of equity risk premium can have a very signiﬁcant impact on value. Given its importance it is therefore surprising how diﬃcult and unstandardized the estimation is in practice (Damodaran, 2015). ERP is generally estimated using historical returns, by investigating the diﬀerence in annual returns on stocks versus bonds over a long time period. As Damodaran(2015) explains this method has its limitations even in established markets like the US, and will likely not be eﬀective in the Icelandic market. There are other methods like the survey method, where investors and managers are asked to assess the risk premium in a large survey. Or the implied approach, where a forward-looking estimate of the ERP is estimated using current equity prices or risk premiums in non-equity markets like bond or real-estate (Damodaran, 2015). It is therefore not an easy task coming up with an exact estimation of the risk premium. The risk premium seems to be somewhere between 3% and 8% for most markets. Damodaran (2015) estimates the total Icelandic equity risk premium 5,76%, using equity market volatility relative to the S&P500 index. Here a risk premium of 6% seems reasonable.

9.4 Cost of Capital

As mentioned before, Icelandair’s Risk Premium (RP) is the multiple of the beta and the equity premium: F irm RPF = RPE × β

Using the estimations above, Icelandair’s estimated risk premium can be calculated as:

RPF = 6% × 0, 775 = 4, 65%

Now with both, the term structure of risk-free interest rates and the risk premium, Icelandair’s term structure of cost of capital can be estimated.

1((0, 906 + 0, 61 + 0, 81)/3) 9.4 COST OF CAPITAL 67

F RPtτ = (1 + ιtτ )(1 + RPF ) = (1 + ιtτ )(1 + 0, 465)

13% 12% 11% 10% 9% 8% 7% 6% 5% 0 5 10 15 20 25 30 35 Years to maturity

Risk free Risk adjusted interest rate Risk adjusted forward rate

Figure 9-3: Term structure of Icelandair’s cost of capital. 68 ESTIMATION OF ICELANDAIR’S COST OF CAPITAL 10| Valuation

In this chapter all previous analysis and information is put to use in estimating Icelandair’s intrinsic value. The valuation in this chapter will rely on the forecast made in Chapter8 and the term structure of cost of capital from Chapter9. The valuation is performed using the methods described in Chapter2(Valuation Methodology), where forecasted ReOI are valued using the APV valuation method. To get a broader range of the intrinsic value, two extra scenarios will be valued as well, one where the forecast exceeds expectations and another that fails to meet expectations.

10.1 Icelandair Base Case Valuation

As stated before the valuation is based on the forecasting assumptions made in Chapter8 which were largely based on the quantitative industry analysis from Chapter7. For the base case valuation, Icelandair is valued using two scenarios for long-term Sales Growth (SG) one in line with the forecast from Chapter8 and another where long-termSG converges towards the central banks inﬂation target of 2,5%. The long-term assumptions for the ReOI value drivers’ growth can be seen in Table 10-1.

Table 10-1: Base case value driver forecast assumptions.

Forcast estimation Long-term mean (a) Long-term mean (a) Persistence (w) ATO 3,1× 3,1× 0,703 PM 4,5% 4,5% 0,763 SG 5,0% 2,5% 0,419

Using these assumptions as well as the estimation of the term structure of cost of capital from Chapter9, the valuation of Icelandair’s intrinsic value is formed. As discussed in Chapter8 the forecasting period is split up into three segments, an explicit period, a fade period and a continuation value. Here the continuation value is calculated using two diﬀerent methods. First using Gordon’s growth model, with the continuation growth rate set as the long-term mean ofSG estimated in Section 8.2.1 of 5%. This might be a high estimate of perpetual SG and therefore, long-termSG is also set to a more modest 2,5% and theCV calculated using that growth rate. The second method is using the long-run estimation of market-to- book ratio (EV/NOA) from Section 7.2.2 to calculate theCV. TheCV is also calculated for both long-termSG estimates using the multiple method. Both models are based on the same forecast for the explicit and fade period. Gordon’s growth model requires a constant interest rate for discounting and therefore the term structure of interest rates needs to be stable before calculation of theCV, this results in a fade period of 15 years following the initial 5-year explicit period. The EV/NOA method does not have the same limitation and therefore uses a shorter fade period of 10 years. Table 10-2 summarizes the results from the base case valuation. 70 VALUATION

Table 10-2: Summary of Icelandair’s Base case valuation.

Gordon’s EV/NOA Gordon’s EV/NOA growth model Multiple growth model Multiple Long-term SG 5% 2,5% Terminal Growth, Multiple 5% 1,5x 2,5% 1,5x P PV ReOI 533.260 505.437 512.345 491.499 PV NOA 307.942 307.942 307.942 307.942 PV of CV 67.430 151.460 33.303 127.548 Firm value 908.632 964.838 853.590 926.989 NFA 148.589 148.589 148.589 148.589 Equity value 1.057.221 1.113.427 1.002.179 1.075.578 Shares outstanding 4.750.000 4.750.000 4.750.000 4.750.000 Share price (USD) 0,2226 0,2344 0,2110 0,2264 FX rate (8.4.2016) 123,74 123,74 123,74 123,74 Share price (ISK) 27,54 29,01 26,11 28,02 * All amounts are in USD thousands, except the ﬁnal share price shown in ISK.

The two methods with the two long-termSG give a value per share ranging from 26,11 to 29,01 ISK per share. This is the base case estimation for Icelandair’s intrinsic value per share. This is a relatively narrow range and the diﬀerence in method forCV does not yield a large diﬀerence to the overall value. TheCV represents between 3,32% and 13,60% of the equity value, highest for the multiple method with a long-termSG of 5% and lowest for the Gordon’s growth model using 2,5% growth. Eﬀects of changes in assumptions on value drivers and other metrics on the estimated value per share for Icelandair will be analyzed in Chapter 11(Sensitivity Analysis).

10.2 Scenario Analysis

The previous section portrayed a valuation based on the assumptions made throughout the thesis, however the future is uncertain and the forecasted estimations assumed for the base case may not hold. In this section two additional scenarios, one optimistic and one pessimistic, will be examined and Icelandair’s intrinsic value per share calculated based on these new assumptions. The scenarios are estimated as an optimistic and pessimistic view while still maintaining realistic estimates of the future and will form additional bounds to the value range. Forecast graphs for the value drivers for both scenarios can be seen in Appendix E.

10.2.1 Optimistic Scenario Valuation

As seen in the forecast analysis in Section 8.1.1, Icelandair’sSG had slowed down. For this scenario however, the explicit periodSG is assumed to be stable at 15% throughout the period, but will revert to the average long-term mean of 8% from the quantitative industry analysis in Chapter7 with a persistency of 0,42. ThePM is assumed to decrease slower during the 10.2 SCENARIO ANALYSIS 71 explicit period and fade to a higher long-term level of 6% with the same persistency of 0,76 as in the base case. ATO will increase during the explicit period, from 4,4× in 2015 to 4,9× in 2020. From there it will fade to a long-term level of 4,0× with the same persistency of 0,703. Again theCV is calculated using the long-termSG level and an increased EV/NOA ratio of 3,5×. Table 10-3 show the resulting value per share given this scenario.

Table 10-3: Summary of Icelandair’s Optimistic scenario valuation.

Gordon’s EV/NOA growth model Multiple Terminal Growth, Multiple 8,0% 3,5x P PV ReOI 840.081 700.418 PV NOA 307.942 307.942 PV of CV 779.116 642.921 Firm value 1.927.140 1.651.280 NFA 148.589 148.589 Equity value 2.075.729 1.799.869 Shares outstanding 4.750.000 4.750.000 Share price (USD) 0,4370 0,3789 FX rate (8.4.2016) 123,74 123,74 Share price (ISK) 54,07 46,89 * All amounts are in USD thousands, except the ﬁnal share price shown in ISK.

The result is a value ranging from 46,89 to 54,07 ISK per share. Here the range is much greater and can mostly be traced to the diﬀerence in the value of theCV.ACV calculated with a growth rate of 8% is obviously very optimistic and results in 38% of the equity value in theCV.

10.2.2 Pessimistic Scenario Valuation

For this scenario the forecast is assumed to be worse than for the base case valuation. For this scenario Icelandair is not able to increase itsSG to former levels and will experience less growth in sales during the explicit period.SG is expected to fade to a long-run level of 2,0% with a low persistency of 0,25. Proﬁt margins will decline for the explicit period, and fade towards a long-run level of 3,0% with less persistency of 0,5. ATO will decline from 4,4× in 2015 to 3,4× in 2020 during the explicit period and then fade towards a long-run level of 2,5× during the fade period. EV/NOA used to calculate theCV is also lower. Table 10-4 show the resulting value per share based on this scenario. 72 VALUATION

Table 10-4: Summary of Icelandair’s Pessimistic scenario valuation.

Gordon’s EV/NOA growth model Multiple Terminal Growth, Multiple 2,0% 0,5x P PV ReOI 261.567 295.026 PV NOA 307.942 307.942 PV of CV -57.824 -76.604 Firm value 511.685 526.364 NFA 148.589 148.589 Equity value 660.274 674.953 Shares outstanding 4.750.000 4.750.000 Share price (USD) 0,1390 0,1421 FX rate (8.4.2016) 123,74 123,74 Share price (ISK) 17,20 17,58 * All amounts are in USD thousands, except the ﬁnal share price shown in ISK.

This scenario results in a value per share ranging from 17,20 to 17,58 ISK per share. Here theCV using both the Gordon growth formula and the multiple method is negative. With such a high cost of capital and low estimates of growth in value drivers, ReOI become negative quickly. Given these estimates, ReOI have turned negative by 2023 and Icelandair would face a decision on how they can adapt. 11| Sensitivity Analysis

A sensitivity analysis measures the sensitivity of an output to a change in a given input while keeping other inputs constant. This type of analysis is useful to evaluate the sensitivity of Icelandair’s estimated value per share to the diﬀerent inputs in the valuation and to see which inputs have the greatest eﬀect on the calculated value. Here Icelandair’s estimated value will be tested to changes in the value drivers used to calculate future ReOI, that is the Proﬁt Margin (PM), Asset Turnover (ATO) and Sales Growth (SG), as well as other inputs to the APV model. The sensitivity is analyzed for the valuation using both methods for calculating theCV. Figure 11-1& 11-2 show the eﬀect a 30% increase and decrease in the inputs have on the calculated value per share and Figure 19& 20 in Appendix F show the percentage change in value per share.

Long-run PM

Long-run ATO

PM Persistency

Target Capital Structure 30% Beta Equity -30%

ATO Persistency

Long-run SG

Terminal Growth Rate

SG Persistency

20 22 24 26 28 30 32 34 36 Share Value (ISK)

Figure 11-1: Share value sensitivity to 30% change in inputs - Gordon’s Growth formula.

Figure 11-1 shows that the valuation using the Gordon’s growth formula to calculateCV is most sensitive to changes in long-runPM and ATO while much less sensitive to long-runSG levels. BothPM and ATO were seen to have high persistency in Chapter7(Quantitative Industry Analysis), indicating that companies are able to sustain their advantage whileSG had a much lower persistency. However, Figure 11-2 shows that using the market-to-book (EV/NOA) ratio method to calculate theCV, is less sensitive to long-term value driver levels. This is likely due to the fact that this method uses a shorter fade period. Instead ERP and the Firm Beta have the greatest impact on calculated value per share. Calculating theCV using the market-to-book method is obviously sensitive to the chosen long-term EV/NOA, but the valuation using the Gordon’s growth model is not very sensitive to the chosen terminal growth rate. The target capital structure and equity beta seem to have similar eﬀect on the value for both methods. Over all using the market-to-book ratio seems to be much less sensitive 74 SENSITIVITY ANALYSIS

Long-term EV/NOA

Beta Equity +30% Target Capital Structure -30%

25 26 27 28 29 30 31 32 33 34 Share Value (ISK)

Figure 11-2: Share value sensitivity to 30% change in inputs - NOA/EV Multiple. to input variation. As Figure 19& 20 in Appendix F show, a ±30% change in a single input can have close to 30% increase or decrease eﬀect on the calculated value per share using the Gordon’s growth formula, but only around ±10% when using the market-to-book premium. Table 11-1 and 11-2 show the value per share calculated for diﬀerent levels of long-termPM and persistency. Sensitivity tables for other value drivers can be seen in Appendix F. The tables show clearly that an increasing estimation of the long-term value and persistency of the value drivers will increase the estimate of value per share. As discussed, the valuation using the EV/NOA multiple method of calculating theCV seems to be less sensitive to changes in long-term value drivers. However, it is necessary to keep in mind that the multiple method uses a shorter fade period than the Gordon’s growth model.

Table 11-1: Sensitivity analysis for Proﬁt Margin - Gordon’s Growth formula.

Persistence (w) PM 0 0,25 0,5 0,75 1 3,00% 17,42 17,78 18,46 20,35 36,58 3,50% 20,21 20,51 21,09 22,71 36,58 4,00% 23,00 23,25 23,73 25,07 36,58 4,50% 25,79 25,98 26,37 27,43 36,58 5,00% 28,57 28,72 29,00 29,79 36,58

Long-term (a) 5,50% 31,36 31,46 31,64 32,16 36,58 6,00% 34,15 34,19 34,28 34,52 36,58

Table 11-3 and 11-4 show the sensitivity of the valuation to the estimation of the ERP, for both methods and long-termSG. As discussed in Section 9.3, ERP is hard to estimate with 75

Table 11-2: Sensitivity analysis for Proﬁt Margin - EV/NOA method.

Persistence (w) PM 0 0,25 0,5 0,75 1 3,00% 23,56 23,92 24,60 26,31 32,30 3,50% 24,83 25,14 25,72 27,18 32,30 4,00% 26,10 26,36 26,84 28,05 32,30 4,50% 27,38 27,57 27,96 28,92 32,30 5,00% 28,65 28,79 29,08 29,79 32,30 5,50% 29,92 30,01 30,20 30,66 32,30 Long-term (a) 6,00% 31,19 31,23 31,32 31,54 32,30 high certainty and a ERP of 6% was chosen for the estimate of cost of capital for Icelandair. A lower ERP will lower the cost of capital and therefore increase the estimated value per share, while a higher ERP will have the inverse eﬀect. As discussed above and clearly illustrated in Figure 11-2, ERP is the most sensitive input for the method using the long-term EV/NOA multiple to calculateEV, however Figure 19& 20 in Appendix F and Table 11-3 and 11-4 show that variation in ERP has a greater eﬀect on the calculated value using the Gordon’s growth formula to calculateCV. This shows that even a ±1% in ERP can have a signiﬁcant impact on the estimated value per share. The sensitivity analysis shows a clear problem with the ReOI APV valuation method. Some of the most impactful inputs in the model are also some of the most uncertain. For both methods the ERP, the beta and target capital structure have signiﬁcant impact on the calculated value. Since these are hard and maybe impossible to estimate correctly, it shows a clear weakness of the method. 76 SENSITIVITY ANALYSIS

Table 11-3: Sensitivity of valuation to ERP estimation- Long-term Sales Growth 5%.

Gordon’s growth 5% SG EV/NOA multiple, 5% SG ERP Value per share (ISK) ERP Value per share (ISK) 4,2% 34,10 4,2% 32,62 4,5% 32,75 4,5% 31,97 4,8% 31,51 4,8% 31,34 5,1% 30,39 5,1% 30,73 5,4% 29,36 5,4% 30,14 5,7% 28,41 5,7% 29,56 6,0% 27,54 6,0% 29,01 6,3% 26,73 6,3% 28,46 6,6% 25,98 6,6% 27,94 6,9% 25,28 6,9% 27,43 7,2% 24,63 7,2% 26,94 7,5% 24,01 7,5% 26,46 7,8% 23,44 7,8% 25,99

Table 11-4: Sensitivity of valuation to ERP estimation - Long-term Sales Growth 2,5%.

Gordon’s growth 2,5% SG EV/NOA multiple, 2,5% SG ERP Value per share (ISK) ERP Value per share (ISK) 4,2% 30,53 4,2% 31,31 4,5% 29,67 4,5% 30,72 4,8% 28,87 4,8% 30,15 5,1% 28,11 5,1% 29,59 5,4% 27,41 5,4% 29,05 5,7% 26,74 5,7% 28,53 6,0% 26,11 6,0% 28,02 6,3% 25,51 6,3% 27,53 6,6% 24,94 6,6% 27,05 6,9% 24,41 6,9% 26,58 7,2% 23,90 7,2% 26,13 7,5% 23,41 7,5% 25,69 7,8% 22,95 7,8% 25,26 12| Multiple Valuation

A valuation based on multiples is carried out as a complement to the ReOI APV valuation. The multiple valuation is based on the assumption that the market prices companies correctly on average. With this assumption it is possible to value Icelandair based on calculated multi- ples for its peer group. Icelandair is valued using three commonly used multiples and a special multiple used for the airline industry, these are EV/EBIT, EV/EBITDA, P/E and EV/EBIT- DAR. Three of them are so called enterprise multiples where the Enterprise Value (EV) 1 of the company is divided with a chosen metric, EBIT and EBITDA are the most popular metric for this type of multiple. EV/EBITDAR is a multiple specially used for the airline industry as it can capture characteristics of the industry better than the standard enterprise multiples. EBITDAR represents the earnings before interest, taxes, depreciation, amortization and for airlines leasing costs. Therefore, enabling a comparison of airlines regardless of their strategy to ﬁnance their ﬂeet. The price to earnings (P/E) multiple is an equity multiple, calculated as the share price divided by earnings per share. The multiples and their values can be seen in Table 12-1.

Table 12-1: Multiple valuation - peer group multiples. Own creation, data from (Bloomberg, n.d.-c).

EV/EBIT EV/EBITDA EV/EBITDAR P/E SAS 4,9x 2,9x 2,1x 13,3x Norwegian 82,2x 19,3x 7,7x 46,3x Finnair 5,2x 1,6x 3,0x 7,7x Airberlin 10,8x 7,4x 1,1x -34,4x

Average 25,8x 7,8x 3,5x 8,2x Median 8,0x 5,2x 2,6x 10,5x

Norwegian being the only low cost airline in the group seems to be an outlier in terms multiples, with values high above the rest. Therefore, a median rather than an average value of the multiple is used in order to give a better ﬁt. Multiplying the estimated median multiples from the peer group with their corresponding metric from Icelandair will yield an estimation ofEV for theEV multiples but the estimated share value for the earnings multiple. The equity value is then calculated by subtracting net debt from theEV and ﬁnally the value per share is gathered by dividing the equity value by the number of shares outstanding.

Table 12-2: Icelandair Value per share based on multiple valuation.

EV/EBIT EV/EBITDA EV/EBITDAR P/E Value per share (ISK) 20,26 21,56 8,93 23,53

1EV = Equity value + Debt − Cash and short term investments + minority interest 78 MULTIPLE VALUATION

Table 12-2 shows the results from the multiple based valuation. The P/E ratio gives the highest value of 23,53 ISK per share, while the EV/EBITDA ratio gives the lowest 8,93 ISK per share. Icelandair seems to be trading at a signiﬁcantly higher EV/EBITDAR than the median for the peer group. The other three ratios give a close range between 20,26 to 23,53 ISK, which is still fairly low compared to the value from the ReOI APV valuation. As stated before this approach to valuation rests on the assumption that the companies selected in the peer group are of the same kind as the company being valued and therefore the large value range is likely the result of the variance between the companies selected. Although the peer group was selected to be as close to Icelandair as possible within similar markets, there may still be too much diﬀerence between them to give an accurate estimation of value. An example of this is that Icelandair owns a larger portion of its ﬂeet than the other companies. It is also likely that only four companies do not provide enough sample to use a multiple analysis with accuracy. With such few comparable companies, any miss-pricing by the market can have signiﬁcant impact on the valuation. The multiple analysis valuation method is a quick way of estimating equity value and is only done as sanity check here. The multiple analysis conﬁrms the result from the ReOI APV valuation, that Icelandair is overpriced by the market. 13| Conclusions

The purpose of this thesis was to determine the intrinsic value per share of Icelandair’s stock and thus challenge the market price on April 8th 2016. In order to estimate the value of Icelandair’s equity it was necessary to evaluate the company’s future prospects. To do so the research covered both ﬁnancial analysis of Icelandair as well as the airline industry’s characteristics and key value drivers, both in a strategic analysis and in a quantitative industry analysis. Following the crisis in 2008, Icelandair went through a ﬁnancial restructuring, extending maturities on debt and issuing new equity and most importantly disinvesting most of its non-core operations. In my opinion this disinvestment was a crucial step in securing the company’s future as it put the focus on creating value from the core operations. In 2011 Icelandair announced that its restructuring was complete and has since then been operating its core business of passenger air transportation, along with its tourism operations, with good results. The key macro-economic factors inﬂuencing Icelandair seem to be economic prosperity (mea- sured in GDP) in the Euro area, North America and Iceland along with fuel prices that are directly linked to crude oil prices. From the introduction of the airline industry in Section 3.4 it was seen that even as an industry of high historical growth, airlines have found it hard to be proﬁtable in the longer term and the industry appears to be very cyclical. The strategic analysis in Chapter5 provided evidence of this. The demand for air travel appears to be highly correlated to economic prosperity, measured in GDP. When GDP rises or declines, the demand for air travel follows. GDP had been growing until 2015 when it declined in the Euro area, Iceland and for the world. Icelandair’s largest operating costs are fuel and employee related costs. Fuel is the largest single operating cost, accounting for 25% of Icelandair’s operating expenses in 2015. Fuel prices, which are strongly correlated to crude oil prices, can be extremely volatile and hard to predict. Oil prices started to decline in 2014 and reached a bottom of 26$ per barrel mid- January 2016. This is positive for airlines in general as ﬁlling their planes is now cheaper. Since the bottom in January, oil prices have been rising and in early April were already close to 40$ per barrel. Given the amount of oil reserves, a sharp increase in fuel price seems unlikely and therefore proﬁt margins are not expected to be impacted by sudden price movements of fuel in the near future and Icelandair’s hedging strategy will lessen the eﬀect that any such movements might have. Wages and other personnel expenses together, represent 30% of Icelandair’s operating costs. Strong unions in Iceland, for both pilots and the ﬂight crew puts upwards pressure on this expense for Icelandair and further makes it diﬃcult to reduce wages or staﬀ if the economy turns. The power of the unions was clear in 2014 as the pilot strike set a precedent for future negotiations. With renegotiations coming up in 2017, there is a threat of instability as strikes may lead to delays and even cancellations of ﬂights. Deregulation of the airline industry increased competition enormously in the industry. In recent years it has mostly been the low-cost airlines driving ticket prices down. Icelandair’s main competitor is an Icelandic low cost airline, WOW air. With Iceland’s popularity as a tourist destination growing so rapidly competition is growing fast, and Icelandair faces increased competition as more airlines add Iceland as a destination to their route network. 80 CONCLUSIONS

However, as seen in the Internal analysis (Section 5.3), Icelandair has a sustainable advantage with its long operational history in Iceland, which grants it control over a large portion of the airport slots available at Iceland’s only international airport. This along with Iceland’s geographical positioning enables Icelandair to operate its unique route network and ensure a dominant position in the Icelandic market. Given that Iceland is an island in the middle of the Atlantic Ocean and most of Icelandair’s revenue come from passenger transportation between North-America and Europe along with passenger to and from Iceland, there is no eﬃcient alternative to air travel. Therefore, there are no alternative mode of transportation or substituting products that Icelandair has to worry about. The ﬁnancial statement analysis revealed the impact things analyzed in the strategic part have had on Icelandair’s ﬁnancials, as well as other signiﬁcant factors. The trend analysis showed a high growth in operating revenues and a decrease in operating costs resulting in a doubled operating proﬁt for Icelandair from 2012 to 2015. At the same time comprehensive income nearly tripled. This high level of growth is not expected to last long into the future, but instead slow down year from year. Operating assets have increased in 2015 as Icelandair is expanding its ﬂeet and with further addition to the ﬂeet in 2016 as well as the large increase starting in 2018, Icelandair’s capacity (ASK) will increase. The common size analysis showed clearly the eﬀect of declining fuel costs as Icelandair’s aviation expenses decreased signiﬁcantly in 2015 as a percentage of total operating income. As expected salaries and other personnel expenses increased slightly in 2014 as a percentage of total operating income and remain signiﬁcantly higher than its peer group. Salaries and other personnel expenses are high for Icelandair compared to its peer group, representing 25% of total operating income for Icelandair, while only 15% for most of its selected peers. The proﬁtability analysis revealed that Icelandair operates with a signiﬁcantly higher proﬁt margin compared to its peer group. With the drop in fuel prices Icelandair saw itsPM soar to over 12%. This is not estimated to be sustainable and is forecasted to decrease to its previous level in the next following years. Icelandair further has a signiﬁcantly higher return on net operating assets over the ﬁve-year period compared to its peer group. However, return on common equity is only slightly higher for Icelandair than the peer group in 2015. The quantitative industry analysis revealed how value drivers of ReOI have evolved for com- panies within the airline industry. The fade diagrams are great to visualize what to expect for the diﬀerent value drivers within the industry and the autregression gives a clear quantitative value of the long-run level and the persistency for the value driver. The airline industry shows a high persistency in asset turnover, slightly less for proﬁt margins and low for sales growth. The forecast is split into two periods, an explicit period of 5 years and a long-term fade period. For the explicit forecasting period ReOI value drivers were forecasted using the information from previous sections of the paper to estimate how sales, asset turnover and proﬁt margin will likely grow in the near future. The long-term forecast for the fade period relies heavily on the quantitative industry analysis, where value drivers are faded to their long-run levels. Icelandair’s cost of capital was calculated using an estimation of the term structure of risk free interest rates with a constant risk premium. The term structure of zero-coupon risk free interest rates is estimated from Icelandic non-indexed government bonds using the Nelson- Siegel model. The Icelandic bond market is unusual, as bond yields in Iceland are very high compared to Scandinavia and most other markets in Western Europe or North America and 81 the Icelandic yield curve is ﬂat and slightly negative. This results in a high cost of capital used to discount future ReOI in the valuation process. The valuation was performed using the forecasted value drivers to calculate future ReOI which were risk adjusted using the APV method. For the base case valuation two diﬀerent long-run level of sales growth were used, 5% and a more conservative 2,5%. The continuing value was estimated using two diﬀerent methods, the Gordon growth formula and a market- to-book premium (EV/NOA). The result is a base case value ranging from 26,11 to 29,01 ISK per share. On the valuation date (8.4.2016) Icelandair’s share price was 37,3 ISK. The base case valuation therefore suggests that the market is overpricing Icelandair somewhere between 30-40%. Along with the base case, two extra scenarios are considered, an optimistic and pessimistic, and the value estimated based on the new inputs. The optimistic scenario yields a value range from 46,89 to 54,07 ISK per share and the pessimistic scenario a value range from 17,20 to 17,58 ISK per share. The scenarios were kept realistic and not too extreme. It is worth noting that the ReOI become negative quickly in the pessimistic scenario, this is largely due to a low PM. With negative ReOI, Icelandair would need to adjust to these new situations or simply go out of business. However, I believe Icelandair is well prepared to take on less favouring market situations, with a solid ﬁnancial standing and a strong equity ratio, if it came to that. A sensitivity analysis was performed on the valuation model to see which inputs had the most impact on the calculated value. The sensitivity analysis reviled that long-runPM and ATO have the greatest impact on the calculated value when using the Gordon’s growth formula to calculateCV, but ERP and the ﬁrm beta when using the market-to-book premium. The diﬀerence is mostly due to discrepancy in the fade period length. As Gordon’s growth formula requires a constant interest rate for discounting and therefore needs the term-structure of cost of capital to be stable before calculating theCV, resulting in a longer fade period. ERP and the beta are next in line for the valuation using Gordon’s growth formula. This high sensitivity for these two uncertain input shows a clear weakness in the APV model. The sensitivity analysis also revealed that using the Gordon’s growth formula to calculate CV also results in a more input sensitive valuation than when using the market-to-book premium to calculate CV. A multiple analysis was performed in order to triangulate the value obtained from the ReOI APV valuation. The peer group was used for this valuation. The multiple valuation gave a value ranging from 20,26 to 25,53 ISK per share with the exception of EV/EBITDAR where Icelandair was valued at 8,93 ISK per share. The peer group may have been too small to get an accurate valuation based on this method. It however conﬁrms the base case valuation that Icelandair is overpriced by the market on April 8th 2016. Figure 13-1 shows the valuation summary for Icelandair. 82 CONCLUSIONS

Market Price 8.4.2016 37,30

EV/EBITDAR 8,93

Multiple valuation 20,26 25,53

Optimistic Scenario 46,89 54,07

Pessimistic Scenario 17,20 17,58

Base Case Valuation 26,11 29,01

0 ISK 10 ISK 20 ISK 30 ISK 40 ISK 50 ISK 60 ISK

Figure 13-1: Summary of Icelandair’s valuation.

I am conﬁdent that the valuation and analysis is sound and that the value of Icelandair is most likely in the range of 26 to 29 ISK per share. I therefore conclude that the market price on April 8th 2016 of 37,3 ISK is too high and Icelandair is overpriced by the market. This result is supported by the multiple analysis, which suggest a lower value ranging between 20 and 26 ISK per share. However, the scenario analysis indicates that if conditions change there is both a signiﬁcant upside and downside potential. References

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List of Acronyms

APV Adjusted Present Value

ASK Available Seat Kilometer

ATO Asset Turnover

BC Bankruptcy Cost

CAGR Compound Annual Growth Rate

CAPM Capital Asset Pricing Model

CASK Cost per Available Seat Kilometer

COMPUSTAT Compustat Capital IQ Global databank

CSE Common Shareholders Equity

CV Continuing Value

ERP Equity Risk Premium

EV Enterprise Value

FA Financial Assets

FL Financial Liabilities

FLEV Financial leverage

FO Financial Obligations g Growth Rate

GDP Gross Domestic Product

IATA International Air Transport Association

ICAO International Civil Aviation Organization

IMF International Monetary Fund

LCC Low-Cost Carrier

NBC Net Borrowing Cost

NFA Net Financial Assets

NFO Net Financial Obligation 88 GLOSSARY

NOA Net Operating Assets

NPV Net Present Value

NS Nelson Siegel

OA Operating Assets

OECD Organization for Economic Co-operation and Development

OI Operating Income

OL Operating Liability

PESTE Political & Legal, Economical, Sociocultural, Technological and Environmental

PESTEL Political, Economical, Sociocultural, Technological, Environmental and Legal

VRIO Valuable, Rare, Imitability and Organization

PM Proﬁt Margin

RE Residual Earnings

ReOI Residual Operating Income

RNOA Return on Net Operating Assets

ROCE Return On Common Equity

RP Risk Premium

RPK Revenue Passenger Kilometer

SG Sales Growth

SIC Standard Industrial Classiﬁcation

SSR sum of squared residuals

TS Tax Shield

WACC Weighted Average Cost of Capital Appendix A

Appendix for Chapter3(Presentation of Icelandair and the Airline industry)

Figure 2: Icelandair’s international route network (Icelandair Group hf, n.d.-e).

Table 1: Icelandair top shareholders at yearend 2015. Adopted from (Icelandair Group hf, 2016b)

Name Shares in ISK Shares in % thousand Stefnir Sjodir 743.793 14,88 Lifeyrissjodur verslunarmanna 729.136 14,58 Lifeyrissjodur starfsmanna rikisins 439.300 8,79 Gildi -lifeyrissjodur 316.706 6,33 Staﬁr lifeyrissjodur 181.287 3,63 Stapi lifeyrissjodur 167.447 3,35 A.C.S. safnreikningur 141.899 2,84 Landsbref - Urvalsbref 141.262 2,83 Sameinadi lifeyrissjodurinn 140.745 2,81 Islandssjodir - IS Hlutabrefasjodur 127.962 2,56 3.129.537 62,59 Other shareholders 1.845.003 36,90 Treasury shares 25.460 0,51 Total issued shares 5.000.000 100,00 90 GLOSSARY

InternationalInternational

Figure 3: Market segmentation for world air travel in 2014. Own creation, data from (MarketLine, 2015).

0,92% 7,44% Americas

Asia-Pacific

34,37% Europe 25,07% Middle East

Rest of the World

Figure 4: Geography segmentation of world air travel in 2014. Own creation, data from (MarketLine, 2015). Appendix B

Appendix for Chapter6(Financial Analysis)

Reformulated Equity Statement 2012 2013 2014 2015 Minority interest previous year 29 Book value of shareholder equity beginning of period 263.356 295.645 345.556 364.321 Net transacons with common shareholders (6.308) (11.760) (18.994) (17.943) Share issues Share repurchases Dividends (6.308) (11.760) (18.994) (17.943) Comprehensive income available to common shareholders 38.854 61.910 37.967 109.419 Net Income 44.275 56.418 66.499 111.223 Other Comprehensive Income (5.421) 5.492 (28.532) (1.804) Preferred dividends 0 0 0 0 Non-controlling interest 257 239 208 104 Closing book value of common equity 295.645 345.556 364.321 455.693

Figure 5: Reformulation of Icelandair’s Equity Statement. Adopted from Icelandair’s An- nual Reports.

Rao Analysis 2012 2013 2014 2015 Dividend payout 16,24% 19,00% 50,03% 16,40% Dividends-to-book value 2,09% 3,29% 4,96% 3,79% Retenon rao 83,76% 81,00% 49,97% 83,60% Return on Common Equity (ROCE) 13,90% 19,31% 10,70% 26,69% Net investment rate 2,40% 3,98% 5,50% 4,93% Growth rate of CSE 12,36% 16,96% 5,49% 25,11%

Figure 6: Ratio analysis of Icelandair’s Equity Statement. Adopted from Icelandair’s Annual Reports. 92 GLOSSARY

Reformulated Income Statement

2012 2013 2014 2015

Operating income Operang income ...... 898.866 1.022.957 1.113.297 1.139.699 Operang expenses ...... 789.220 879.247 958.959 920.717 109.646 143.710 154.338 218.982 Depreciaon and amorsaon ...... (58.859) (70.699) (75.329) (83.826) Share of proﬁt (loss) of associates ...... (366) (38) (216) 459 Operating income before tax and dirty surplus 50.421 72.973 78.793 135.615 Proﬁt from disconnued operaon, net of tax ...... 0 0 2.074 0 Tax as reported ...... (13.173) (14.630) (15.483) (29.000) Operating income after tax, before dirty surplus 37.248 58.343 65.384 106.615 Currency translaon diﬀerences ...... (2.285) 4.204 (5.403) (1.686) Net loss on hedge of investment, net of tax ...... (46) 169 (15) 0 Net investment hedge reclassiﬁed to proﬁt or loss ...... (1.417) (111) 719 0 Eﬀecve poron of changes in fair value of cash ﬂow hedge, net of tax (1.673) 1.230 (23.833) (118) Operating income after tax and dirty surplus 31.827 63.835 36.852 104.811

Financial expense Finance income ...... 17.578 6.777 7.194 12.818 Finance costs ...... (10.551) (8.702) (6.079) (8.210) Financial expense after dirty surplus 7.027 (1.925) 1.115 4.608

COMPREHENSIVE INCOME 38.854 61.910 37.967 109.419

Figure 7: Reformulation of Icelandair’s Income Statement. Adopted from Icelandair’s An- nual Reports. 93

Reformulated Balance Sheet

2012 2013 2014 2015 Net Operating Assets: Operang assets Operang assets ...... 282.997 299.197 319.340 419.071 Intangible assets and goodwill ...... 176.715 179.676 175.973 172.694 Investments in associates ...... 1.327 2.035 2.324 18.223 Deferred cost ...... 3.648 258 153 118 Receivables and deposits ...... 9.223 15.791 16.413 27.474 Inventories ...... 17.417 22.166 22.906 19.205 Trade and other receivables ...... 135.085 114.259 96.470 101.075 Total operang assets 626.412 633.382 633.579 757.860

Operang liabilies

Payables ...... 22.060 23.742 8.291 8.644

Trade and other payables ...... 152.237 159.504 214.315 219.680 Deferred tax liabilies ...... 19.671 27.995 24.681 35.485 Deferred income ...... 122.089 153.535 174.944 186.109 Total operang liabilies 316.057 364.776 422.231 449.918

Net Operang Assets 310.355 268.606 211.348 307.942

Net Financial assets: Financial assets Short term investments ...... 15.734 7.955 30.879 19.533 Cash and cash equivalents ...... 117.060 191.538 184.762 194.586 Assets classiﬁed as held for sale ...... 3.689 0 0 0 Total ﬁnancinal assets 136.483 199.493 215.641 214.119

Financial liabilies Loans and borrowings ...... (119.358) (78.489) (49.671) (55.387) Loans and borrowings ...... (31.548) (43.528) (12.263) (10.143)

Total ﬁnancinal liabilies (150.906) (122.017) (61.934) (65.530)

Net Financial Assets (Obligaons) (14.423) 77.476 153.707 148.589 Non-controlling interests ...... 257 239 208 104 Common shareholders' equity 295.675 345.843 364.847 456.427

Figure 8: Reformulation of Icelandair’s Balance Sheet. Adopted from Icelandair’s Annual Reports. 94 GLOSSARY

100% Icelandair Average 90%

% of Total Operating income

0% Transport revenue Other operating Salaries and other Aviation expenses Other operating revenue personnel expenses expenses

Figure 9: Common size analysis for selected income statement items, peer group comparison. Own creation, data from companies Annual Reports. Appendix C

Appendix for Chapter7(Quantitative Industry Analysis)

4,5x 0,75 0,75 0,80 0,70 4,0x 0,62 0,70 3,5x 0,60 3,0x 0,50 2,5x 0,40 2,0x 4,1x 0,30 1,5x 3,1x 3,1x Persistency 2,2x 0,20

ATO Long-run ATO Long-run Level 1,0x 0,5x 0,10 0,0x 0,00 Peer Group Peer Group Industry Average including excluding Icelandair Icelandair

ATO Persistence (w)

Figure 10: Long-run levels and persistency for ATO. Own creation, data from (COMPUSTAT, n.d.). 96 GLOSSARY

7,0% 0,90 0,76 0,80 6,0% 0,65 0,61 0,70 5,0% 0,56 0,60 4,0% 0,50

3,0% 6,2% 0,40

0,30 Persistency 2,0% 4,3% 3,6%

PM Long-run PM Long-run Level 3,1% 0,20 1,0% 0,10 0,0% 0,00 Peer Group Peer Group Industry Average including excluding Icelandair Icelandair

PM Persistence (w)

Figure 11: Long-run levels and persistency for PM. Own creation, data from (COMPUSTAT, n.d.).

14,0% 0,60 0,52 0,50 0,25 12,0% 0,50 0,42 10,0% 0,40

Level 8,0% 0,30 6,0%

0,20 Persistency 4,0% 11,6% 8,4% 6,8% 6,8%

SG Long-run SG Long-run 2,0% 0,10

0,0% 0,00 Peer Group Peer Group Industry Average including excluding Icelandair Icelandair

SG Persistence (w)

Figure 12: Long-run levels and persistency for sales growth. Own creation, data from (COMPUSTAT, n.d.). 97

12,0% 0,44 0,50 0,40 0,45 10,0% 0,08 0,40 0,35 8,0% 0,31 Level 0,30 6,0% 0,25 9,5% 0,20

4,0% 7,7% Persistency 6,8% 6,9% 0,15

NOA NOA Long-run 0,10 2,0% 0,05 0,0% 0,00 Peer Group Peer Group Industry Average including excluding Icelandair Icelandair

NOA growth Persistence (w)

Figure 13: Long-run levels and persistency for NOA growth. Own creation, data from (COMPUSTAT, n.d.).

14,0% 0,70 0,61 0,45 12,0% 0,40 0,49 0,60 10,0% 0,50

6,0% 12,2% 0,30 11,3% 10,9%

9,1% Persistency 4,0% 0,20

RNOA Long-run RNOA Long-run Level 2,0% 0,10

RNOA Persistence (w)

Figure 14: Long-run levels and persistency for RNOA. Own creation, data from (COMPUSTAT, n.d.). 98 GLOSSARY

1,8x 1,00 0,88 0,58 1,6x 0,90 1,4x 0,68 0,71 0,80 0,70 1,2x 0,60 1,0x 0,50 0,8x 1,6x 1,5x 1,4x 0,40

0,6x Persistency 1,1x 0,30 0,4x 0,20 EV/NOA Long-run EV/NOA Long-run Level 0,2x 0,10 0,0x 0,00 Peer Group Peer Group Industry Average including excluding Icelandair Icelandair

EV/NOA Persistence (w)

Figure 15: Long-run levels and persistency for EV/NOA growth. Own creation, data from (COMPUSTAT, n.d.). Appendix D

Appendix for Chapter9(Estimation of Icelandair’s Cost of Capital)

Price error 2,5% 2,0% 1,5% 1,0% 0,5% 0,0% -0,5% 0 2 4 6 8 10 12 14 16 -1,0% -1,5% -2,0% -2,5% -3,0%

Figure 16: Nelson-Siegal pricing errors. 100 GLOSSARY UMR OUTPUT SUMMARY necp ,05001 ,18001 ,08007 ,080,0073 1,2538 0,0018 0,9172 0,0073 1,2538 0,0018 0,9172 0,0015 0,0000 3,2138 12,6988 5,E-29 0,0855 0,0014 0,2106 0,0005 161,2594 0,0808 1,0855 0,1298 0,0045 0,0808 260 259 1 1 Variable X Intercept Total Residual 261,0000 Regression 0,3837 0,0224 0,6194 0,3813 ANOVA Observations Error Standard Square R Adjusted Square R R Multiple ersinStatistics Regression oﬃinsSadr ro ttPvleLwr9%Upr9%Lwr9,%Upr95,0% Upper 95,0% Lower 95% Upper 95% Lower P-value Stat t Error Standard Coeﬃcients fS SFSgicneF Signiﬁcance F MS SS df al 2: Table qiybt ierregression. linear beta Equity Appendix E

Appendix for Chapter 10(Valuation)

Historical Explicit Fade 18% 6,0x PMPM SGSG ATOATO 16% 5,0x 14%

10% 3,0x 8% ATO

0% 0,0x 2013 2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039

Figure 17: Forecast period for ReOI value drivers. Optimistic scenario.

3,5x 12% 3,0x 10% 2,5x 8% ATO

PM SG & 2,0x 6% 1,5x

Figure 18: Forecast period for ReOI value drivers. Pessimistic scenario. 102 GLOSSARY Appendix F

Appendix for Chapter 11(Sensitivity Analysis)

-30% -20% -10% 0% 10% 20% 30% % change in value per share

Figure 19: Share value sensitivity to 30% change in inputs - Gordon’s Growth formula.

-15% -10% -5% 0% 5% 10% 15% % change in value per share

Figure 20: Share value sensitivity to 30% change in inputs - NOA/EV Multiple. 104 GLOSSARY

Table 3: Sensitivity analysis for Asset Turnover - Gordon’s Growth formula.

Persistence (w) Asset Turnover 0 0,25 0,5 0,75 1 1, 6× 7,74 8,55 9,82 13,23 31,41 2, 1× 17,13 17,54 18,22 20,06 31,41 2, 6× 22,91 23,12 23,49 24,48 31,41 3, 1× 26,83 26,93 27,11 27,60 31,41 3, 6× 29,66 29,69 29,76 29,93 31,41 4, 1× 31,80 31,79 31,78 31,74 31,41 Long-term (a) 4, 6× 33,47 33,44 33,38 33,19 31,41

Table 4: Sensitivity analysis for Asset Turnover - EV/NOA method.

Persistence (w) Asset Turnover 0 0,25 0,5 0,75 1 1, 6× 22,96 23,77 25,04 27,44 29,73 2, 1× 25,65 26,06 26,73 28,09 29,73 2, 6× 27,30 27,51 27,87 28,64 29,73 3, 1× 28,42 28,52 28,70 29,09 29,73 3, 6× 29,23 29,26 29,33 29,47 29,73 4, 1× 29,84 29,84 29,82 29,79 29,73 Long-term (a) 4, 6× 30,32 30,29 30,22 30,07 29,73

Table 5: Sensitivity analysis for Sales Growth - Gordon’s Growth formula.

Persistence (w) Sales Growth 0 0,25 0,5 0,75 1 3,50% 26,43 26,64 27,04 28,04 35,58 4,00% 26,64 26,86 27,25 28,24 35,58 4,50% 26,87 27,08 27,46 28,45 35,58 5,00% 27,11 27,32 27,69 28,66 35,58 5,50% 27,36 27,56 27,93 28,89 35,58 6,00% 27,62 27,82 28,19 29,12 35,58 Long-term (a) 6,50% 27,90 28,09 28,45 29,37 35,58 105

Table 6: Sensitivity analysis for Sales Growth - EV/NOA method.

Persistence (w) Sales Growth 0 0,25 0,5 0,75 1 3,50% 27,89 28,13 28,57 29,70 35,05 4,00% 28,10 28,33 28,77 29,87 35,05 4,50% 28,31 28,54 28,97 30,05 35,05 5,00% 28,53 28,76 29,17 30,23 35,05 5,50% 28,76 28,98 29,39 30,42 35,05 6,00% 29,00 29,21 29,61 30,61 35,05 Long-term (a) 6,50% 29,24 29,45 29,84 30,81 35,05

Table 7: Sensitivity analysis - Target Capital Structure

GG 5% EV/NOA Target Capital Structure Share Price Share Price 58,4% 29,70 30,33 62,6% 29,31 30,11 66,8% 28,93 29,88 70,9% 28,57 29,66 75,1% 28,22 29,44 79,3% 27,87 29,22 83,5% 27,54 29,01 87,6% 27,22 28,79 91,8% 26,91 28,58 96,0% 26,60 28,38 100,1% 26,31 28,17 104,3% 26,02 27,97 108,5% 25,74 27,77 106 GLOSSARY

Table 8: Sensitivity analysis - Firm Beta

GG 5% EV/NOA Beta Firm Share Price Share Price 54,3% 34,10 32,62 58,1% 32,75 31,97 62,0% 31,51 31,34 65,9% 30,39 30,73 69,8% 29,36 30,14 73,7% 28,41 29,56 77,5% 27,54 29,01 81,4% 26,73 28,46 85,3% 25,98 27,94 89,2% 25,28 27,43 93,0% 24,63 26,94 96,9% 24,01 26,46 100,8% 23,44 25,99 107

Gordon's Growth 5% growth

40,00 ISK EV/NOA multiple, 5% SG

Share Share Price

20,00 ISK 3,0% 4,0% 5,0% 6,0% 7,0% 8,0% 9,0% ERP

Figure 21: Value per share change - ERP.

EV/NOA multiple 0,0x 0,5x 1,0x 1,5x 2,0x 2,5x 3,0x 3,5x 40,00 40,00

35,00 35,00

30,00 30,00

25,00 25,00

20,00 Gordon's Growth Terminal Growth 20,00 EV/NOA multiple 15,00 15,00 0% 2% 4% 6% 8% 10% 12% Terminal Growth

Figure 22: Value per share changes - Terminal growth and long-term EV/NOA.

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Master's Thesis 1 1. Introduction ... valuation method may result in opposite reality that will lead to enormous losses due to the fact these methods are based in different principles. The understanding of principles is crucial so that the analyst in charge of a valuation can choose the
PDF MASTER THESIS Valuation of intangible intensive firms
This thesis will have an explanatory focus, and, acknowledging the difficulty and complexity of performing a thorough valuation of an entire intangible intensive firm from an outsider perspective, it will seek to determine if there is a valuation 'best practice' for intangible intensive firms within the media and entertainment industry.
PDF Unicorns Analysis: An Estimation of Spotify's and Snapchat's Valuation
An important assumption of this method is that the company is depicted by its cash ows only and no other parameter is taken into account. This assumption is critical in the case of unicorns' valuation because it translates the expectations into hard facts. The formula for the DCF is given by: DCF= XT t=1. CF. t.
PDF Valuation of a Startup Zoom Case Study
Master Thesis: Valuation of a Startup Zoom Case Study Author: Ramon Puigderrajols Sanchez Tutor at HEC: Prof. Patrick Legland, Finance Department Supervisor at UPC: ... a proper thesis structure and content, always providing relevant material on which to base by work. Even though the development of this thesis has been developed mainly outside
PDF Project Valuation using Real Options
A thesis submitted for the degree of Master of Advanced Studies in Management, Technology, and Economics ... 3 Valuation of Swiss Re's real case based on the appraisal tech- ... the core of the thesis, treats the valuation of the case study based on the appraisal method presented in part 2.
PDF VENTURE CAPITAL VALUATION METHODS: CHALLENGES AND ...
Master's Degree Final Thesis 3 Abstract The venture capital industry needs to gather their resources and expertise with the aim of developing a standardized guideline system which can help investors reduce the subjectivity of alternative startup valuation methods, which rely highly in qualitative scales and procedures.
PDF Business valuation for small and medium-sized enterprises
The FCFF method can be used to value the entire firm or business. The value of the company is the result of the free cash flow discounted by the cost of capital, in this case the WACC. The origins of firm valuation lies in the work of Modigliani & Miller (1958).6This method relies on the expected free cash flows.
PDF Consistent Outperformance of the Value Investing Paradigm. The
Abstract Author: Natalia Soloviova Title of thesis: Consistent Outperformance of the Value Investing Paradigm. The Performance of Superinvestors and Pragmatic Investors Faculty: LUT School of Business and Management Master's Programme: Strategic Finance and Business Analytics Year: 2020 Master's Thesis: Lappeenranta-Lahti University of Technology
PDF (Major in Strategic Management)
Master in Management - Grande Ecole (Major in Strategic Management) MASTER THESIS Academic Year 2022 - 2023 Start-Up Valuation: Bumble Inc. Case Study Eduardo Blasi Under the supervision of Prof. Patrick Legland Date 08/06/2023 X RAPPORT OUVERT AU PUBLIC - PUBLIC REPORT RAPPORT CONFIDENTIEL - CONFIDENTIAL REPORT
PDF Master thesis
Theoretical segment: Valuation models. In this part of the thesis we will look into the three valuation models chosen for theoretical discussion. First out is the discounted cash flow model. Valuation models: 1)Discounted Cash flow analysis Introduction: A very common valuation model often used in financial textbooks is the discounted cash flow ...
NTNU Open: Developing and Evaluating an Automated Valuation Model for
Developing and Evaluating an Automated Valuation Model for Residential Real Estate in Oslo ... Kristoffer; D'Silva, Allan Daniel. Master thesis. View/ Open. 19153_FULLTEXT.pdf (2.955Mb) ... Institutt for industriell økonomi og teknologiledelse [3011] Abstract. In this thesis, we develop an automated valuation model (AVM) for the residential ...
Masters Thesis: Valuation of Icelandair
The valuation date is set after the market closes on April 8th 2016 and at the date of the valuation, Icelandair's share price is at an all-time high of 37,3 ISK. The thesis sets out to investigate whether this price is justiﬁed or if Mr. Market is oﬀ. 1.2 Problem statement.
Sebastian afflerbach ruiz
master thesis on the valuation of distressed firms conceptual framework and case application name: sebastian afflerbach cpr: institution: copenhagen business Skip to document University
Valuation of Tesla Motors
Student thesis: Master thesis. ... Based on these estimates, a valuation is carried out, and it is estimated that the valuation of Tesla is 0.82% over market price when discounted cash flow method is used and valued over market price with ~2.55% when economic value added model is used. The last part of the paper tests the sensitivity of the ...
PDF GUIDELINE FOR MASTER'S THESIS EVALUATION
The thesis supervisor submits a written statement on the thesis with a proposal for a grade, i.e. an evaluation statement to the Degree Programme Committee. When preparing the report, the supervisor may also request statements from the advisor(s). In cases where the supervisor has proposed the grade '5' or '1' or 'fail', the Degree ...
Palantir After Q1 Earnings: Market Misreads Metrics, AIP Bet Still
Thesis: Palantir has shown excellent US commercial growth, the AIP asymmetric bet still holds. Palantir reported a +131% growth in US Commercial Total Contract Value (TCV) in Q1 2024, an ...
PDF Master Thesis On the Valuation of distressed rms A conceptual framework
Second, the predominant traditional valuation methods will be introduced and their major drawbacks when applied in a distressed valuation scenario will be analyzed. Third, a valuation approach will be introduced, based on traditional val-uation techniques, but will include certain adaptations to account for factors