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.