mperial ir Group

Imperial Air GroupFebruary 28, 2002

Frank Burke

Jared Lawrence

Gurkan Salk

David Watson

Travis Young

mperial ir Group Agenda

• Case Introduction

• Recommendation

• Valuation

• Options

• Conclusion – Case Update

mperial ir Group Case Synopsis

• Lufthansa is considering an investment in Chinese airline

mperial ir Group Learning Objectives

• Cost of capital considerations

• Comprehensive DCF Modeling (debt restructuring, optional cash flows)

• Strategic Bidding

• Identification of Option Value

mperial ir Group Why the deal is happening

• China Aviation Industry Consolidation– CAAC effort to revitalize industry

• WTO Acceptance– Will boost Chinese aviation market – Need to be more cost effective– Increased competition

mperial ir Group Imperial Air Group

• Flagship Chinese international carrier

• Industry consolidation expands domestic presence

• Strategic partner would increase operational efficiencies

mperial ir Group Lufthansa AG

• German national carrier

• Europe’s most profitable airline in 2000

• History of investing in China– Existing relationship with Imperial Air

• Looking to diversify international revenues – 63% in Europe

mperial ir Group The Deal

• 20% stake in Imperial Air

• Debt restructuring

• IPO in 2 years– Conditional on performance targets – Additional equity offering of 15%

• Multiple strategic bidders

mperial ir Group Recommendation

• Bid $483 million

• Competitive bid, w/ NPV = $73MM

• Lufthansa is best strategic fit

• Comps analysis not meaningful

0100

200300

400500

600700

Bid

mperial ir Group DCF Model

• Comprehensive 10 year projections

• Main Issues– Revenue Projections– Alliance/Consolidation Benefits– Fuel Costs– Debt Paydown– IPO

mperial ir Group DCF Model

Projecting Airline Revenues

• Passenger Revenue = RPM * Yield• RPM highly correlated with GDP growth• Yield subject to typical competitive forces

(supply & demand, price wars, business cycles)

mperial ir Group Risk Assessment

Operational • Government restricts air routes• Fuel Prices

Financial • Risk of a delayed IPO• High Leverage

Sovereign Risk • Low expropriation risk• High creeping expropriation risk• Low currency risk

mperial ir Group Cost of Capital

• Assumptions:– Risk free rate: 5.5%– Market risk premium: 4%

• ICCRC Cost of Capital

ICCRC Rate 17.8%

Currency Risk (1.3%)

Adjusted CoC 16.5%

mperial ir Group DCF NPV Results

E[NPV] = 607.5MM Rmb, S.D. = 997MM, P[NPV>0] = 72%

Frequency Chart

Certainty is 72.15% from $0.0 to +Infinity

.000

.008

.016

.024

.032

0

16

32

48

64

($2,109.0) ($767.1) $574.9 $1,916.8 $3,258.8

2,000 Trials 12 Outliers

Forecast: NPV

mperial ir Group Multiples Analysis

• Acquisition Multiples – Not meaningful, due to regional and other

differences

• Trading Multiples– P/E: Regional differences, Imperial

negative earnings– EBITDAR: Best multiple for industry, but

also problematic due to high leverage

mperial ir Group

• Financial– Anti-Dilution option to purchase additional

shares at 25% discount in the event that Imperial Air Group conducts an IPO

– Value = $6.2 million

• Real– Option to invite Imperial Air Group into the

Star Alliance– Expansion of cargo service in China

Option Value to Lufthansa

mperial ir Group

• WTO agreements did not liberalize Chinese air markets

• CAAC has opposed debt-to-equity conversions– Some consolidations are in jeopardy

• “Imperial Air” (larger) and CNAC (financially stronger) are in dispute over who should lead the consolidated “Imperial Air Group”

• Smaller independent airlines have formed an alliance to compete with the majors

Conclusion – Case Update

mperial ir Group Learning Objectives

• Cost of capital considerations

• Comprehensive DCF Modeling (debt restructuring, optional cash flows)

• Strategic Bidding

• Identification of Option Value