Background

Following the outline, the financial analysis provides detailed insights into the operational performance of easyJet regarding: (i) income statement, (ii) balance sheet, (iii) value, (iv) revenue, and (v) cost drivers, (vi) profitability, (vii) asset and liability, (viii) liquidity and solvency ratios⁹², as well as (ix) red flags and golden nuggets, also in (x) comparison with its peers⁹³. The analysis covers one business cycle of the airline industry, which according to academic literature and findings comprises a minimum of seven years (Liehr, Groesler, Klein, & Milling, 2001), in order to not overlook issues, that only occur in certain phases of the cycle, e.g.

when the number of aircraft operated is increased extraordinary strongly to answer perceived market potential⁹⁴. Consequently, the review period, i.e. the seven years the financial analysis refers to, comprises the years from 2010 to 2016 (both years included). The financial analysis, the trends identified here and in the strategic analysis will shape the model forecast and thus lay the foundation for answering the research question.

Based on this and in order to prepare for answering the research question, especially the following sub-questions are answered in this section:

What is the industry’s reporting structure like? Are there any industry specifics? If so: which? How did the financial performance of easyJet and its peers develop over the review period⁹⁵? Have the companies been profitable over the entire review period/in each and every review year? How did easyJet perform relative to its peers? Is it financially healthy enough for investments improving profitability further? How do profit and loss accounts react when varying industry specific drivers?

3.1.1 Audit Opinions

The data for the analyses are taken from the peers’ published annual reports, which must (at least) meet the requirements and quality standards defined by the relevant national authorities. Since 2005, the International Financial Reporting Standards (IFRS) represent the reporting requirements applicable in the United Kingdom.

Consequently, easyJet must apply these standards when conducting its consolidated financial statements (IFRS, 2016). Its financial reports must then be independently audited; in the case of easyJet PricewaterhouseCoopers (PwC) provided the audits from 2010 onwards and has not ever since expressed any

92 Financial ratios, such as profitability ratios, are fundamental when it comes to evaluating a business and its performance. As these ratios are industry specific, the analysis responds to economic characteristics of the airline industry (Petersen & Plenborg, 2012).

However, more important than the analysis of numbers, is the interpretation and evaluation of the results (Stepanyan, 2014).

93 To better understand easyJet’s business model, its competitive strengths and weaknesses, this section analyses the peer’s financials, too (Soliman, 2008).

94easyJet for instance, once took 16 new aircraft on in one year, compared to the long term average of 10 p.a. (calculated over the entire review period). That year’s exceptional situation may have triggered one off effects (e.g. an exceptionally low load factor, extraordinary high training and/or integration costs), that may force misleading conclusions, if only this specific year is looked at.

95 The review period, i.e. the seven years (i.e. review years) the historic review refers to, comprises the years 2010 to 2016 (both years included).

32 relevant complaints. However, PwC has outlined four areas that require special attention: (i) aircraft maintenance provisions, (ii) treasury operations, (iii) judgmental accruals and provisions, and (iv) goodwill and landing rights impairments (easyJet, Annual Report 2016, 2016). As aircraft can for instance be bought using cash (or cash equivalents) generated e.g. from past activities or loans or be leased through financial or operational leases and maintenance provision depend on the chosen way of financing. All other things left equal, these options result in different profit and loss accounts and balance sheets⁹⁶. When comparing different carriers, the financial statements need to be reformulated, too, for instance different types of leases have to be adjusted and accounted for in the same manner (Gritta, Lippman, & Chow, 1994). An airline’s treasury operations (e.g. hedging activities) are also important for an assessment of the relative quality of revenues, as carriers may deploy different approaches to forward exchange contracts used to hedge currency risks.

Judgmental accruals and provisions include items, such as customer claims in respect of flight delays, which can be complex by nature and difficult to account for. As these kind of provisions may only be relevant in the industry, a special focus is needed to avoid misrepresentations. Landing rights, too, are a key revenue driver, as they decide which routes an airline can serve. They are allocated in accordance with guidelines set by the IATA’s Worldwide airport slots group, including a categorization into different levels⁹⁷ (IATA, Worldwide Slot Guidelines 8th Edition, 2017). As landing slots can be traded⁹⁸ and, therefore, can have a substantial commercial value, they are reflected in the balance sheets and PwC warns to not overestimate such values to create unfounded assets (easyJet, Annual Report 2016, 2016).

3.1.2 Accounting Policies

After confirming the audit opinions, the accounting policies applied over the review period are analyzed to eliminate the noise, if any, which may result from changes and could lead to wrong conclusions when analyzing the historic statements. However, no such substantial changes made over time in the accounting policies of the peers are to be observed. Nevertheless, there were changes in IFRS over the course of the review period, of which one is worth pointing out: effective January 1, 2013 IAS19 was changed, forcing easyJet to state its pension deficits on the balance sheet. Before the change, the corridor method of accounting was used to show the difference between actuarial gains and losses. The method allowed a company to amortize the differences over the expected remaining lifetime of the beneficiaries in the income statement. Following the new rule, companies have to recognize the actuarial adjustment in the comprehensive income at the time of occurrence. However, in easyJet’s case (a relatively young company with “few” employees), the change did

96Due to the purchase price of an aircraft – an A319 e.g. cost around USD 85.8 m (Airbus, New Airbus aircraft list prices for 2014, 2017) – the industry is capital intensive and depending on the way of financing a fleet of several hundred planes, maintenance provisions can vary substantially.

97 Level 1 airports are defined as non-coordinated airports, while Level 2 Airports are defined as schedules facilitated airports, and Level 3 airports are defined as coordinated airports (Administration, 2017).

98 In January 2017 Delta Airlines e.g. bought one weekly slot at Heathrow from Croatia Airlines for USD 19.5 m (McWhirter, 2017).

33 not have a large effect (PricewaterhouseCoopers, 2013).

3.1.3 Reformulation of Statements

Reformulation of financial statements is necessary for two main reasons: (i) to show the real profitability of the core business (i.e. its operating performance, operating and operational are used interchangeable in this context) and (ii) to make the

peers’ reports comparable. A specialty of easyJet’s is its financial year, which starts on October 1 and lasts until September 30 of the subsequent year ⁹⁹ . As Ryanair’s 12 months’ financial year ends on March 31 and Southwest’s and Norwegian’s end of December, the difference needs to be

accounted for, to e.g. ensure all intercompany comparisons properly reflect the underlying operations and strategy. As the analysis looks at the key drivers of the peers’ business models’ “real” profitability, it makes sense to solely look at the operating performance, i.e. how their core business is doing, and therefore a distinction between operating and financing activities is essential (Easton, Wild, Halsey, & McAnally, 2008)¹⁰⁰. As said before, airlines can finance their aircraft in different ways. To allow for comparing the peers, all leases are converted into capitalized leases, and the required adjustments on both, the income statement and balance sheet are made (Gritta, Lippman, & Chow, 1994)¹⁰¹. Consequently, non-recurring items are excluded, too, as they would also misrepresent the actual operational performance of the respective year (Penman, 2012).

As a result of the reclassification two new key drivers are introduced: (i) invested capital and (ii) NOPAT (net operating profit after tax). Consequently, the income statements and the balance sheets of all four peers¹⁰² have been reformulated for all seven review periods to allow for comparison across time and carriers (Petersen &

99 easyJet’s financial year 2015 e.g. starts October 1, 2014 and lasts until September 30, 2015 (easyJet, Annual Report 2015, 2015).

100 The focus of the analyses is on the operating performance, because looking at the total (i.e. operating plus financial) might be misleading, as for instance the development of e.g. the total net income, could be mainly driven by non-core or for the peer group comparison not relevant financial decisions.

101 The adjustments follow the relevant academic literature (Gritta, Lippman, & Chow, 1994).

102 As Norwegian do not publish a detailed financial statements for each quarter, it is not possible to reformulate their quarterly reports and therefore the reformulation of the accounts is made pro rata based on their annual reports.

Figure 9: Overview of Peers' Financial Year

34 Plenborg, 2012)¹⁰³.