JetBlue Airways Corporation Essay
JetBlue Airways Corporation
JetBlue Airways Corporation was formed in August 1998 as a low-fare, low-cost but high service passenger airline serving select United States market. JetBlue’s operations strategy was designed to achieve a low cost, whilst offering customers a pleasing and differentiated flying experience. JetBlue has had a successful business model and strong financial results during that period, and performed well in comparison to other airline companies in the US during the period between 2000 and 2003. It had been the only other airline apart from Southwest airlines, to have been profitable during the aftermath of the September 11, 2001 attacks on World Trade Center, and at a time when the entire airline industry was experiencing losses.
The core of JetBlue’s strategy was low operating cost achieved through a smaller and more productive workforce; utilizing aircraft efficiently; better use of technology to achieve lower distribution cost i.e. use of electronic ticket as against paper ticket; use of brand new single model planes that reduced maintenance costs and training costs at the same time. However, moving into the growth phase, JetBlue was contemplating expansion with the introduction of a new model of planes, i.e.
Embraer E190, that are smaller than the A320s that they were using. These planes were to be utilized for penetrating mid-size cities and also during off-peak times on existing routes. The company defined these markets as destination with 100 to 600 local passengers per day each way, compared to the much larger markets that the company was serving with its A320s. This had potential implications for its low-cost strategy.
Jetblue’s expansion required investments in areas other than just new aircraft. Owen needed to decide how to raise additional capital to fund the company’s growth. Investment bankers had presented two financing proposals; a new public equity offering and a private placement of convertible debentures. Own needed to decide which proposal, if any, to recommend to the board.
In early 2003, JetBlue continue to see opportunity to grow by adding both new market and new flight to existing destination. One of such new market where the company believed there was attractive opportunity was the mid-sized market segment which comprised of destinations with 100 – 600 local passengers per day each way. To accommodate this growth, the company is seeking to purchase 65 new Airbus A320, with an option to buy additional 50 new aircraft, and also committed to purchase 100 Embraer E190 aircraft, with the option to purchase 100 additional ones. Jetblue had embarked on a $6.8 billion plane acquisition program that would increase its aircraft fleet from 45 to 252, including existing aircraft purchase commitment.
The company needs thus to think about a way to finance those acquisitions, as well as other needed investments such as spare parts, new engines, additional hangars and a flight training centre
JOHN OWEN THE CFO OF JETBLUE IS TRYING TO DECIDE WHICH OF TWO FINANCING PROPOSALS (NEW PUBLIC EQUITY OFFERING AND A PRIVATE PLACEMENT OF CONVERTIBLE DEBENTURE) TO PURSUE. A straight equity issue will dilute his principal shareholders’ ownership, but favored a conservative capital structure that would help to ensure JetBlue’s financial flexibility, access to capital and a favorable lending rate. On the other hand, a convertible debt alternative seems less dilutive, and cheaper, but brings with it an increased risk of default and financial problems.
The financing decision taken by the CFO is important because of the positive impact it is expected to have on the current and future performance of the JetBlue. The considerations as regards impact of the financing decision are discussed;
IMPACT ON CURRENT PERFORMANCE OF THE COMPANY
It is expected that the new capital would ease Jetblue’s ability to finance its short term obligations as JetBlue does not have a line of credit, or short-term borrowing facility. Therefore, the company depends on its operating cash flow to finance its short-term obligations
The new capital will be required to finance working capital requirement of Jetblue, Working capital is the short term resources that are used to manage the business on a daily basis. This is otherwise referred to as current asset.
The financing decision which is aimed at securing the purchase of the new 100-seat Embraer E190 aircraft would allow JetBlue to enter smaller markets while maintaining low operating costs, and increase flight frequency on existing routes. The low fares offered by JetBlue would allow it to attract new passengers who might otherwise not fly. Earnings from this market segment is expected to contribute to the profitability and positive financial performance of the company
IMPACT ON FUTURE PERFORMANCE OF THE COMPANY
The additional capital is expected to strengthen the company’s balance sheet at a time when JetBlue will be shouldering a significant amount of debt related to new aircraft deliveries.
The decision on financing method would result in a strong capital structure for Jetblue which would ensure that the company would continue to grow while avoiding financial problems.
The new cash inflow which is directed at ensuring JetBlue achieves its expansion activities. It is expected that the company will be in a position to purchase larger volumes of jet fuel and would thus have more leverage in procuring fuel than today. The company will thus suffer relatively less from fuel shortages and the negative impact a rise in fuel has an operating income
John Owen the CFO of JetBlue generally favored a conservative capital structure. A conservative funding strategy is when a firm finances both its seasonal and permanent requirement with long term debt.
The criteria which John Owen used to evaluate his decision on the appropriate capital structure and mode of financing to support the expansion drive of the business are;
FINANCIAL FLEXIBILITY: This refers to the firm’s ability to take advantage of unforeseen opportunities or their ability to deal with expected events depending on the firm’s financial policies and financial structure. A firm with a high debt obligation and weak solvency and liquidity is not financially flexible.
FAVORABLE LENDING RATE: The lending rate to a business varies directly with the risk associated with any given financial structure which can be accessed by leverage analysis. It is expected that a higher leverage (as a result of accepting debt offering) tends to amplify a firm’s predictable business swings i.e. associated risk. This inclines to increase lending rate to the firm and ultimately result in an unfavorable lending rate.
CONTROL: The financing scheme of a company can imply changes in control constrains on the firm, this can be indicated by percentage distribution of share ownership and structure of debt covenant. There is a high chance that the board of directors will not favor the equity offering as they were sensitive about the dilution (i.e. control dilution) that an equity offering would cause to existing shareholders.
INCOME: This compares financing tactics on the basis of their effect on value creation and distribution i.e. the impact on Earnings per share (EPS) and Return on equity (ROE). The debt option limited the ability of Jetblue to manage one of the airline’s principal risk; rising fuel prices. As discussed above, the debt offering afforded Jetblue less financial flexibility. If fuel prices rose unexpectedly, operating income will decline thus hurting JetBlue’s ability to meet the additional debt service payments.
Other criteria John Owen could use to evaluate his decision on the appropriate capital structure and mode of financing are;
Timing: This considers whether the current capital market environment is the right time to implement any alternative financial structure and what the implication for future financing will be if the proposed structure is adopted. Financial market condition often favour one or another kind of financing.
Others: This is the consideration of the impact of the alternative financing choice on other issues and vice versa. An example is the ability to use collateral to reduce the costs and risk of debt financing and the effect of various financing tactics on the liquidity of investment.
REASONS WHY JOHN OWEN SHOULD PROPOSE THE EQUITY FINANCING OPTION
From the above analysis, it can be deduced that using equity financing option minimizes the company’s weighted average cost of capital, thus maximizes the overall stock price of the company and the shareholders’ wealth.
The NPV of the company is higher under the equity financing option
JetBlue, as any airline company has a debt to equity ratio of 61.21% and incurs very high fixed costs as a result of high value operating property and equipment. An equity offering would increase the financial flexibility of the company.
The company has a very high operating leverage as a result of variability in fuel price. This exposes the company to the risk of cash flow projections errors in case it does not meet the projected revenues figures. Any variation in the estimated revenues, might lead the company to a position where it could not meet its financial obligations related to debt. From this point of view, JetBlue needs to secure its cash flows. This can be achieved using equity financing.
The lending rate to a business varies directly with the risk associated with any given financial structure which can be accessed by leverage analysis. Issuing equity will reduce the leverage of business and reduce lending rate.
Other financing option I would like to recommend to the board and John Owen are;
JetBlue can consider some other alternatives as well. Indeed, the company can issue some preferred stock. This stock might be considered as equity in accounting, to strengthen the balance sheet of the company, but will at the same time accommodate the board members’ concern about dilution.
Another alternative might be the issuance of simple corporate bonds. The coupon rate for those will however be higher than the 3.5% of the convertible bonds. This option will thus cost more for JetBlue than convertible bonds
Aviation fuel cost is the second largest operating cost in the airline industry after payroll, this has significant impact on operating and financing risks of a company.
IMPACT ON OPERATING RISK:
In 2002, JetBlue’s fuel cost amounted to $76 million or 14.4% of operating cost. In the event that fuel prices rises, there will be a significant drop in operating income and higher exposure to operating risk (risk created by operating leverage). Operating leverage is the magnification of the top half of the income statement, it measures how EBIT changes in response to changes in sale, and the relevant cost is the fixed cost of operating the business. It is expected that as operating leverage increase due to jet fuel increase, the operating risk of the business likewise increases.
IMPACT ON FINANCING RISK
In the event that jet fuel rises, it is expected that operating profit will drop and operating leverage would increase. This will also hurt JetBlue’s ability to meet the additional debt service payment i.e. it may face risk of default or potential financial loss which is known as financial risk. Financing risk is the risk associated with financing and its created by financial leverage. Financial leverage is the magnification of the bottom half of the income statement, it measures how EPS (earnings per share) changes in response to changes in sale, and the relevant cost is the fixed cost of financing, in particular interest.
The operating and financing risk exposure of JetBlue through rising fuel price of JetBlue has being managed in the past through hedging 75% of its fuel using a combination of CALL OPTIONS, SWAPS AND COLLARS hedging instrument.
Fuel hedging is a contractual tool some large fuel consuming companies such as airlines (JetBlue) use to reduce their expose to volatile and potentially rising fuel cost. A fuel hedge contract allows a large fuel consuming company to lock in the cost of future fuel purchase, allowing an increasing number of airlines to avoid surprises from unforeseen cost fluctuations. The hedging could be done via a commodity swap or option. One of the basic reasons why a company enters into hedging contract is to mitigate their exposure to future fuel prices that may be higher than current prices and/or to establish a known fuel cost for budgeting and predictability of earnings.
PRINCIPAL WAYS JETBLUE HAS BEING USING HEDGING TO MANAGE FUEL PRICING RISK:
Jetblue is a small airline which had less leverage in procuring large volume of jet fuel in order to mitigate risk of volatility or shortage of jet fuel. In order to mitigate fuel pricing risk, Jetblue used a combination of fuel call option, swaps and collars hedging instrument. From time to time Jetblue has simply bought call options which tend to be at least $5 per barrel.
HOW THE HEDGING INSTRUMENT WORKS
The hedging instrument mostly used by JetBlue is the call option.
CALL OPTION: This is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the option has the right but not the obligation to buy an agreed quantity of a particular commodity (jet fuel) from the seller of the option at a certain time (the expiration date for European call option or at any time during the life of the option for American call option) for a certain price (the strike price). The seller is obligated to sell the commodity (jet fuel) or financial instrument should the buyer so decide. The buyer pays a fee called a premium for this right. In the case JetBlue, the premium it pays is at least $5 per barrel.
SWAPS: Swaps are tailor made futures contract whereby an airline exchanges payment at a future date (which can be in jet aviation fuel and could be further into the future into the future than possible through commodity exchanges), based on the fuel or oil price. There could be an arrangement with a supplier such as Air BP. The airline would buy a swap for a period of say one year at a certain strike price for a specified amount of jet fuel per month. The average price for that month is then compared with the strike price, and if it exceeds it the counter-party would pay the airline the difference times the amount of fuel. However, if it were lower, then the airline would pay the difference. They lock in a given price, as with forward contacts.
COLLARS: This is a combination of a call and a put option. The call protects the holder from adverse price increases above its strike price, at a cost of the option premium that would be paid in any event. The holder of this call also writes a put option that limits the advantage it can take of price reduction below its strike price. The total cost of taking the two options is the call option premium paid less the put option premium received. A collar limits the speculative risk to a small range of price moves and locks in the price that will be paid for fuel between two known values.