European ULCCs – Time Arb Available

Ryan Air (“the Company” or “RYAAY”) is Europe’s largest low cost airline (“LCC”).  The Company’s operations are extremely strong and it’s balance sheet is pristine.  Historically, the Company consistently produced the best margins in the industry.  RYAAY’s income statement is under pressure because Europe has way too much flying capacity and competitors are acting irrationally.  Moreover, Brexit fears and a recently adopted union contract (Ryan Air wasn’t “union” until last year) have investors very nervous about the future.  So nervous that Ryan Air’s ADRs are selling at $70.19/ADR (as of 5/22/2019) vs a high of ~$127.20/ADR (set 11/27/17).

Consequently, Ryan Air’s EV has meaningfully declined:

Note, the current EV is $13.3Bn (excluding leases, which account for 6% of the fleet) on a $12.8Bn market cap.  The company thinks its stock is cheap and just announced a $700mm buyback.  Therefore, roughly 5.5% of shares outstanding will be bought in at arguably attractive prices. 

Importantly, Michael O’Leary, the CEO, is not known to overpay for anything.  Further, he’s demonstrated particularly adept capital allocation. For instance, he made an incredible aircraft purchase following 9/11 and opts to pay a special dividend in order to maintain cash flow optionality.  Given his record, it’s unlikely he is going to meaningfully overpay for stock. Further, he has 112 million reasons to double profits over the next 5 years. See https://skift.com/2019/02/11/ryanair-ceo-michael-oleary-could-get-a-giant-payday-despite-airlines-current-woes/. Thus, I don’t foresee him using cash for anything unproductive at this time. Accordingly, I give this share buyback more weight than others.  

Nevertheless, it’s important to see whether anything fundamentally changed within the company to warrant the downward enterprise value rerating?

Operating Performance

Going back to 2006, Ryan Air’s operating performance has been fairly volatile.  That said, the company’s trends are strong driven by increasingly efficient asset utilization.  A chart may help show this:

As shown in the chart above, over time, Ryan Air generates more sales per dollar of assets employed.  This indicates the Company consistently improves it’s ROE potential.  However, margins are volatile.  Today, margins are within the “normal” historical range.  That’s a pretty impressive feat considering the state of European air travel.  Most importantly, RYAAY’s margins have a reasonably high probability of increasing as the competitive landscape rationalizes.

Competitive Landscape

European air travel demand is remarkably resilient.  Since 2005, passenger kilometers traveled have increased at 4.9% per annum (vs. 2.1% in the US).  JP Morgan attributes that growth to (1) the stimulus of low fares (the low cost carrier (“LCC”) model is younger in Europe than the US); (2) Western European trips/capita well below the US; and (3) under penetrated growth opportunities in Eastern Europe.  Moreover, LCCs grew their share of air travel from 17% in 2008 to 25% in 2018.  This happened because LCCs (1) stimulated air travel with low fares (remember, trains are very viable competitors in Europe); (2) took market share from legacy airlines; and (3) opened new bases at secondary airports.

Here are a couple interesting charts illustrating potential European travel per capita and LCC market share:

Unfortunately, the European airline sector made a classic mistake.  They expanded capacity way too quickly; growing capacity by 8-9% in calendar 4q18.  Estimates suggest 1q19 capacity growth will also be close to 8-9%.  Compare those rates to the 4.9% growth in passenger kilometers traveled and it’s easy to see why there are short term capacity problems.  Michael O’Leary discussed Europe’s airline industry on Ryan Air’s May 2019 conference call:

I’ll bet O’Leary’s comments prove reasonably accurate.  Especially as they pertain to Ryan Air’s ability to weather the storm.  Yes, he is outspoken, brash, and sometimes contradicts himself, but his track record at Ryan Air is impeccable.  Further, his relentless focus on cost cutting is where I want to bet in a commodity game.  That said, avoiding commodity games could be a smarter way to invest.  Regardless, I have a sickness that pulls me toward my perception of value wherever I find it.

See below for some additional context on potential consolidation and the European airline industry’s recent economics:

Ryan Air Business Strategy

Ryan Air is an amalgamation of Walmart, Amazon, and the airline industry.  The company is hyper focused on efficiency.  According to a friend (@Maluna_Cap on Twitter), Ryan Air’s IR department said the entire airline has a call every morning.  After the first wave of flights takes off, the head of each airport dials into a conference call.  On the call they all give status updates.  Managers are expected to explain the reasons behind any and all delays.  Imagine the pressure of having to explain to ~80 peers why your airport performance was poor that day. Needless to say, that culture results in an efficient airline.

Note: Overall on time performance is declining in Europe due airport congestion and inadequate air traffic control infrastructure.

Ryan Air’s strategy is to price seats extremely low in order to drive yield factors.  Beginning in 2014, Ryan Air adopted its own version of “scale benefits, shared.” The airline has consistently dropped price in order to drive yield. Since 2014, prices per passenger declined from €46/passenger to €39/passenger. On average, Ryan Air’s fares are 15-20% lower than its nearest competitor (Wizz), 30-40% lower than EasyJet, and 70-80% less expensive than Lufthansa, IAG, and Air France/KLM.  The result speaks for itself:

Note: Ryan Air pursued the strategy of using fares to stimulate growth

Ryan Air’s low fares stimulate air travel.  Many of RYAAY’s destination airports are secondary airports (think Midway in Chicago rather than O’Hare).  Therefore, they are less expensive to fly into (Wizz benefits from using secondary airports as well).  Moreover, they are looking to increase passenger traffic. This gives Ryan Air negotiating leverage over the airports. Consequently, Ryan Air’s network has structural cost benefits embedded in it; especially against anyone not named Wizz.  Importantly, those cost advantages are hard to replicate because Ryan Air’s scale results in increased discounts.  See below for Ryan Air’s scale advantage:

Next, Ryan Air sells consumers ancillary products.  Similar to a grocery store’s use of milk, Ryan Air prices seats at razor thin margins in order to sell additional upgrades (seat choices, preferred boarding, snacks, etc).  Thus, high load factors help (1) improve (a) revenue (additional people to buy ancillary products), (b) margin (ancillary revenues are almost completely accretive to margins), and (2) reduce costs as Ryan Air can negotiate better rates with airports, as discussed above.

Finally, Ryan Air operates a very young fleet, which it owns.  The young fleet requires less maintenance and downtime.  Therefore, Ryan Air’s maintenance costs are low and fleet utilization is high.  Moreover, Ryan Air carries very modest leverage so the entity avoids a lot of the fixed costs embedded in financing a capital heavy business.

Putting it all together, below is a chart that shows Ryan Air’s costs (CASK), revenues (RASK), and operating profit (EBIT per ASK) vs. Easy Jet and Wizz (note: all units per kilometer, which is the appropriate metric to use; generally longer trips generate more profit):

Business Conclusion

Fundamentally, its hard to see why Ryan Air’s enterprise multiple warrants a long term multiple contraction.  Yes, there are short term issues.  And yes, the decision to recognize unions could hurt the underlying economics of the business in the short term.  However, based on Ryan Air’s history, I suspect they will manage their unions as well as anyone.  Moreover, there is room to raise ticket prices to cover additional costs and still offer incredible value to customers.

Brexit is a major short term concern.  In the event of a hard Brexit, Ryan Air is going to have to work with the EU to structure their shareholders in a way that 50% or more are EU domiciled (due to EU regulations).  Further, there will likely be some travel disruptions as 23% of Ryan Air’s sales come from the UK.

However, it’s hard to see Brexit being a permanent overhang on the LCC travel industry.  Travel existed before Brexit.  One would think rational minds can prevail in order to keep travel occurring after Brexit.  That statement may be debatable.  Regardless, it appears as though extremely poor short term industry dynamics and Brexit concerns resulted in a potential opportunity. 

Valuation

Ryan Air’s relative valuation is pretty low compared to it’s history. While the growth potential may have slowed, it still exists. Slower growth, combined with potentially higher labor costs, would warrant some multiple compression. However, the current rerating seems overdone.

Source: Bloomberg; 5 year Equity Relative Valuation vs. Self
Source: Bloomberg; 2 year Equity Relative Valuation vs. Self

Moreover, the company is guiding to between €700-€950 of profit this fiscal year. That means the offered unlevered earnings yield on the enterprise is 6-8% on depressed earnings. Furthermore, an entering shareholder’s return will benefit from the 5% share buy back authorization.

As of today, I believe Ryan Air is approximately 25%-30% undervalued. I’m basing that on a number of scenarios. The downside risk to my terminal value estimate is approximately 33%, my base case expects terminal value to increase by 58%, and my blue sky scenario expects terminal value to increase 86%. The investment’s realized return will depend on the accuracy of those estimates, the time it takes for the market to realize Ryan Air’s value, and whatever cash flows Ryan Air generates.

In short, I firmly believe the expected value of this bet is positive. My bet is Ryan Air’s current valuation reflects short term (12-18 month) concerns rather than a permanent degradation in operating potential. Accordingly, Ryan Air warrants consideration at these levels.   Disclosure: Purchased a starter position on 5/21/2019 (yesterday); concerned about portfolio construction considering my Delta and Alaska investments.

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Wizz is also interesting around these levels because almost all of the same analysis applies.  Wizz, however, is smaller, younger (still non union), and leases its planes.  Generally speaking, my view is the offered price on Wizz is much closer to intrinsic value.  That said, Wizz will likely reward its shareholders through growth.  In my view, Ryan Air’s current EV and balance sheet provide a reasonable source of margin of safety.  Therefore, I am more comfortable buying the proven asset at a discount to what I think it is currently worth.  Moreover, Ryan Air’s growth isn’t done even if it is going to be slower. 

Airlines – Grounded or Taking Off?

It doesn’t make any sense that Warren Buffett, arguably the greatest quality investor ever, retreated to his “value” roots to invest in airlines. This is the same guy that didn’t let Nike get through his investment filter. And now he invested in airlines? Airlines! The…worst…business…ever. Or is it?

Note: This is not investment advice! An airline investment is extremely risky and should only be undertaken after deep due diligence. If you believe what is written here and buy the shares of any company mentioned you should expect to lose your capital to someone more informed than you. Furthermore, the volatility in airline stocks is not for the faint of heart. Do not let yourself get interested in this idea if you consider Beta to be a meaningful metric.

Airlines: A Brief History

First, some facts must be stated:

  • Airlines will never be a capital light business. They require reinvestment to remain relevant. They may not need to purchase all new airplanes (ahem, American), but they do have to consistently reinvest in the cabin and airport experience.
  • No matter what, people will complain about flying. Very rarely do you hear someone say “Let me tell you how much I enjoy flying commercial airlines.” Usually people say they are being treated like cattle and getting gouged. The gouging claim is particularly interesting considering its never been less expensive to fly, but I digress. See
    https://www.travelandleisure.com/airlines-airports/history-of-flight-costs
  • The history of the airline industry is littered with wasted stakeholder capital. Note, I did not say shareholder. Everyone has had to compromise; shareholders, debt holders, employees, and sometimes customers. Here’s a quick look at a truly horrendous industry history:
Source: BAML

Historically, financially weak competitors wreaked havoc on financially responsible airlines. Usually, the weak competitor had poor cost structures and too much leverage. Combine that with high exit barriers and high fixed costs and you have a recipe for disaster.

Why? Airline seats are commodities. Always have been and probably always will be. Thus, airlines can’t do much when competitors react to financial trouble by pricing seats to cover variable (rather than all in) costs. Once an airline prices seats in that manner, all competing airlines are faced with two bad choices:

  • Don’t match price, lose yield, and pray to cover costs.
  • Match price, lose margin, and pray to cover costs.

Neither of those choices are great. The problem gets exacerbated when the financially distressed competitor files for bankruptcy. Bankruptcy usually enables poorly run/capitalized airlines to restructure their liabilities (such as union contracts, debt arrangements, etc.). Following the bankruptcy proceedings, a new, lean airline emerges to compete against the well run and responsible airline. Thus, responsible airlines have had to compete with poorly run airlines while they were in decline followed by cost advantaged competitors post restructuring. That’s a tough equation.

The Enigma

If all that is true why did Buffett choose to invest in this space? Doesn’t he understand history? Doesn’t he understand that buying a one of a kind brand like Disney at a market multiple is a great bet? Isn’t he the one that said a capitalist should have shot the Wright brothers? Isn’t this the man that said:

“Businesses in industries with both substantial overcapacity and a ‘commodity’ product are prime candidates for profit troubles. Over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over capacity and a new profitless environment.

The Pari-Mutuel System

Buffett understands compounders, capital light compounders, pricing power, quality, and any other phrase you throw at him. But, what I believe he understands better than most is the odds at which each bet stacks up against each other. As Charlie put it:

“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet…The prices [are such]…that it’s very hard to beat the system.” – Charles T. Munger

While the odds offered are important, any damn fool can also tell you a three legged horse isn’t going to win the race. A lame horse is a lame horse. Good odds aren’t going to change that. So, what does Warren see that makes this horse worth betting on?

Industry Facts

Today, 4 major airlines control 80+% of all US seats.

Source: BAML

More importantly, at least 3 of the 4 are financially stable. The one that concerns me the most is American. Doug Parker, American’s CEO, would respond by saying the company’s loan to asset value (“LTV”) is reasonable. I don’t necessary disagree with that thought process. However, I worry about the interest expense (an added fixed cost in a downturn) causing irrational behavior. Given the industry’s history, I’d far prefer American to have a better balance sheet this late in a cycle.

Nevertheless, here is Scott Kirby, President of United, discussing what is “different this time:”

American remains my “canary in the coal mine.” That said, American is acting rational and the Big 4 have been rational since they consolidated. Whether they remain rational in a downturn remains TBD. But, as my friend Jake Taylor mentioned in his book The Rebel Allocator, industries can usually remain rational when they have under 5 major participants…

In the meantime, airlines benefit from:

  • structural tailwinds (people valuing travel and bragging via Instagram; the trend towards urbanization also helps because consumer spending on travel to see family has proven to be resilient),
  • technological advancements (far better scheduling and pricing ability),
  • more efficient, rolling hubs (3 large legacy carriers can run much more efficient hubs than 6 carriers could ever hope to),
  • decoupling of booking fees and ancillary revenues (ancillary revenues are harder to price shop and therefore more inelastic),
  • airport infrastructure that is difficult to expand (gates are somewhat constrained), and
  • the often overlooked credit card agreements.

A Quick Note on Game Theory

Airlines seem to face a prisoner’s dilemma with pricing decisions. A description of the prisoner’s dilemma can be found at
https://en.wikipedia.org/wiki/Prisoner%27s_dilemma. There’s validity to the argument that in any given pricing situation Airline A is incentivized to “cheat” on price in order to gain market share. Since Airline B is afraid of that incentive, Airline B is incentivized to do the same. Thus, they will both end up cheating and aggregate returns will be suboptimal.

However, the prisoner’s dilemma applies to a game played only once. In the airline industry the game is played thousands of times every day. If Airline A cheats on one route, Airline B can respond on a different route. The 4 major participants signal to each other over and over again. They all also respond to these signals. When the game is repeated with such frequency it’s more likely to lead to prices that generate acceptable (though not great) returns.

Therefore, the repetition of the game reduces the potentially destructive incentives to cheat. Borrowing/bending a term from physics, the industry remains in quasi stable equilibrium. See
https://web.ma.utexas.edu/users/davis/375/popecol/lec9/equilib.html.

Competitive Position Assessment

SCG likes the competitive positions of the ultra low cost carriers (Allegiant, Spirit, Frontier), Delta (generates a revenue premium), and Alaska (benefits from a cost advantaged union contract that is unlikely to go away). As I see it, costs are the only way to win consistently in commodity industries. That said, Delta is an incredibly well run airline and has proven revenue premiums are sustainable in this industry. It’s only right to credit Phil Ordway of Anabatic Investment Partners as the original source for that line of thought. His thought process is compelling and I haven’t been able to debunk the reasoning. Disclaimer: Long Delta and Alaska.

Credit Card Agreements: The Gem No One Cares About

The industry’s credit card agreements are immensely profitable for the airlines. Further, the cash flows are growing at reasonable rates and generate free cash flow “float.” Alaska Air Group discussed their credit card agreement at a JP Morgan event. Here’s what they said:

Note: ALK’s enterprise value is $11.4Bn (inclusive of pension obligations and operating leases). So, cash flow from credit card/loyalty agreements totals 8.7% of a fully baked enterprise value.

It’s certainly interesting that Buffett, who’s core competence is financials, just happens to be interested in airline stocks at the same time the industry’s credit card economics improved. Maybe it’s a coincidence. Maybe not.

Interestingly, Delta recently announced that they renegotiated their deal with American Express. See
https://ir.delta.com/news/news-details/2019/American-Express-and-Delta-Renew-Industry-Leading-Partnership-Lay-Foundation-to-Continue-Innovating-Customer-Benefits/default.aspx. That new deal extends the relationship to 2029. Delta expects to generate $7.0Bn of free cash flow from this agreement by 2023 (vs. $3.5Bn in 2018). Of that $7.0Bn, $3.0-4.0Bn will be a “marketing fee.” Marketing fees are pure margin and don’t require Delta to fulfill any obligations. The remaining $3.0-4.0Bn of cash flow has a murkier margin because the benefits usually reduce revenues per flight. That said, if the benefits are used to fill an otherwise empty seat they are virtually all margin since the variable cost of that seat is negligible.

At a minimum these credit card agreements are a very efficient way to finance the business. A bull would argue this portion of the business is a high margin sales organization growing at ~14% per year. What’s that worth? Joe DiNardi, an analyst for Stifel, Nicohaus & Co is asking that same question:

Most importantly, why have the credit card economics changed so much and are these changes sustainable? That was a difficult question to answer. Scott Kirby believes it’s because of the airlines’ improved financial positions. See below:

Mr. Kirby’s explanation is rational. Distressed loans require banks to hold more capital against the loans. That additional capital requires a return. Therefore, the notion that banks historically hit their “hurdle rate” by keeping all the credit card economics makes sense. With the industry in better shape, banks now hold less capital against the loans and probably generate more cash management (and other ancillary) revenues. Thus, they are more willing to give up some of the credit card economics.

Importantly, Delta’s recent announcement seems to suggest the good times will continue for the airlines and credit card commissions. That’s good for all stakeholders.

Why Delta

Now that we’ve established that airlines might be reasonably healthy horses, it’s time to look at the odds offered on the bet. This post will analyze Delta because SCG believes it’s far and away the best run hub and spoke airline in the world. Further, Atlanta is a sustainable competitive advantage for Delta’s network. Atlanta is so valuable because it’s incredibly efficient. Some estimates say Atlanta is up to 200bps more profitable than other hubs. This advantage stems from Delta dominating the hub and Atlanta’s traffic volume.

Perhaps most importantly, Delta can survive turbulent periods. In the event of a downturn, Delta has $1.9Bn of cash, $3.0Bn of revolver availability, and generated free cash flow in 2009. Therefore, Delta can probably handle the left tail of potential outcomes. Delta has $1.7Bn of debt maturities coming due in 2020 and $1.4Bn due in 2022. It would be nice to see them refinance and meaningfully extend the term of that debt. Now is a good time to refinance because debt markets are seemingly starved for yield.

Delta’s Offered Odds

With that in mind, let’s take a look at Delta’s free cash flows available to equity since 2009. This analysis of free cash flow available to equity adds back a proforma adjustment assuming 40% of capex was financed with debt. As of today, Delta’s debt to Net PP&E totals 37%. Delta’s management is pleased with the balance sheet today. Thus, analyzing average free cash flows using a proforma adjustment assuming 40% of capex will be financed going forward is reasonable assumption.

Since 2013, Delta’s average pro forma free cash flow available to equity totaled $4.1Bn per year. As stated, this number rests on the proforma adjustment assuming that 40% of capex was/will be financed. Again, I am comfortable with that assumption because (a) it’s unreasonable to expect Delta to not finance any equipment purchases, (b) the balance sheet is in a reasonable financial position (debt and debt like obligations account for 41% of asset value; those obligations consist of $9.0Bn of pension obligations, $10.7Bn of debt, and $5.8Bn of operating leases), and (c) it’s more important to figure out how the business is going to look going forward rather than what it looked like in the past.

2013 is a valid starting point for the analysis because it is the year the DOJ approved the last of the Big 4 mergers. A reasonable argument can be made that requires the analysis to look back to 2009 (which is why I showed those years as well in the chart above). That said, I base this analysis on the competitive period that is most similar to today.

Going forward, Delta should return most of the free cash flow available to equity to shareholders. Let’s say they use 20% of cash flow to build cash reserves and 20% to voluntarily reduce pension obligations. That leaves about $2.5Bn for dividends and share repurchases. As of 3/31/2019 there were 655mm shares outstanding with a promised dividend of $1.40/share/year. Therefore, Delta will be paying roughly $920mm in dividends annually. Thus, approximately $1.5Bn, or 4% of the current market cap is available for share repurchases. Note, this assumption doesn’t take into account the impending growth in credit card cash flows.

I’d be remiss not to mention that Delta’s market cap includes $2.0Bn of equity investments in other airlines, a refinery that does about $4.0Bn of sales every year (total assets were $1.5Bn at 3/31/19), and a maintenance repair organization (“MRO”). The MRO has run rate revenues of ~$800mm annually with “mid teens” margins. Further, Delta expects the MRO to achieve $2Bn of revenues over the next 5 years. All together lets say the assets mentioned in this paragraph are worth $4.0Bn.

Accepting the assumptions above, Delta currently trades at an 11+% free cash flow available to equity yield. Moreover, they have the opportunity to “buy in” 4% of their shares every year. IF the competition remains rational shareholders have a reasonable chance to earn 13-15% on their capital in the foreseeable future. Those kinds of returns will generate a lot of wealth when rates are below 3%.

The Bet

Returning to Munger for a moment…the airline “horse” may not be the best. But the odds offered are intriguing. Importantly, the horse is reasonably healthy. One question remains: is the future actually different this time? Who knows? Buffett put his chips in. I did too. But, I may be some schmuck that convinced himself an elegant theory was correct because I wanted to believe it so badly. Time will tell. I’ll still be in the position when the story is told.

The beauty of this game is Buffett’s “fat pitch” doesn’t have to be anyone else’s. Regardless of people’s conclusions, it’s important to look at why the greats do what they do. The thesis above isn’t dispositive, but it does hit many of the key points. See also
https://twitter.com/BillBrewsterSCG/status/1010219620131893250 for a bit more industry information.

As always, please feel free to contact me with any questions and/or corrections.

PS. I asked Charlie about the airline investment. He said this:

Recommended Reading/Viewing/Listening

https://www.sec.gov/Archives/edgar/data/1670076/000119312517106522/d366312ds1.htm

See also the Airline Weekly podcast: found at
https://airlineweekly.com/
And really any of the speeches at The Wings Club found on YouTube

The Rebel Allocator is a fantastic and fun book with many pearls of investment wisdom.

PPS. If you liked any of the above commentary look into subscribing to Airline Weekly. Also, follow Phil Ordway @pcordway on Twitter. Phil is the Portfolio Manager at Anabatic Investment Partners LLC. He gave a fantastic presentation to Manual of Ideas that started my research journey. Finally, try to participate in any Manual of Ideas events you can. John Mihaljevic puts on great events and strikes me as a person doing it for the right reasons.