Warren Buffet of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has the tendency of buying stocks that everyone hates at the moment he is getting in. He has demonstrated its habit recently when it purchased in total $8B of stakes in Delta Airlines (NYSE:DAL), American Airlines (NASDAQ:AAL) and Southwest Airlines (NYSE:LUV). This begs the question whether European Airliners offer similar value.
The seven largest carriers in Europe (all with more than 60M passengers in 2016) can be segmented into two broad categories: legacy airlines such as Lufthansa (OTCQX:DLAKF) (OTCQX:DLAKY), International Airlines Group (British Airways and Iberia) (OTCPK:ICAGY) (OTCPK:BABWF), Air France-KLM (OTCPK:AFRAF) (OTCPK:AFLYY) and Turkish Airlines and the two leading low-cost carriers Ireland-based Ryanair (NASDAQ:RYAAY) (OTCPK:RYAOF) and UK-based Easyjet (OTCQX:ESYJY) (OTCPK:EJTTF).
The legacy airlines are all to some extent dealing with a series of issues, such as competition from the low-cost carriers on internal flights and competition from government-backed airlines on long haul flights, frequent strikes, and management issues, which is why low-cost carriers seem to be a far safer bet at this moment.
Ryanair and Easyjet: two similar airlines with different strategies
Ryanair and Easyjet are both low-cost carriers, whose competitive advantage with respect to the legacy airlines lies in having optimized their operations for decades in such a way that they have very lean cost structure. Other moats are their online platforms, that together with their relatively strong brand enable them to interact directly with their customers and use analytics to further improve their bottom-lines. In both companies, the founders are still involved: Ryanair is run by its founder Michael O'Leary, who also has a 3.9% stake in the company. Sir Stelios Haji-Ioannou, founder of Easyjet, doesn't run the company himself anymore but controls about 34% of it as an investor who doesn't shy away from intervening.
The difference between the two lies in the fact that when it comes to routes, Easyjet focuses more on quality, while Ryanair's focus is quantity and cost. In particular, Easyjet cherry-picks popular slots in easy-to-reach airports which are located near to affluent cities. Ryanair, on the other hand, chooses its routes with more focus on cost, even though in the latest reports management declared that it is inclined to lean more towards Easyjet's strategy. This difference in strategy emerges also from the two companies' financial reports, where Easyjet reported in 2016 a cost per seat of GBP 52.26 (ca. EUR 60.32) vs. Ryanair's EUR 47.69. Revenues for Easyjet per passenger were EUR 67.48 (GBP 58.46), down from EUR 72.24 in 2015, while for Ryanair they were EUR 61.43. In other words, Easyjet is able to recoup its higher costs with higher ticket prices, but Ryanair has higher margins.
Another difference lies in how shareholders are compensated: Easyjet has a payout ratio of 50% net income, which results in a GBP 0.538 dividend (already paid for this year), which yields 5.3% at the current share price of a little more than GBP 10. Ryanair, on the other hand, in the past hasn't paid dividends and prefers to return money to shareholders through buybacks.
According to Bloomberg at the current share price, Easyjet is valued 9.1 times earnings (TTM), while Ryanair is valued at 13.9 times earnings. The difference can be explained by two factors. First, since 2010 Ryanair has increased its revenues steadily from EUR 3B to EUR 6.5B, while Easyjet grew them from GBP 3B to GBP 4.7B, i.e. Ryanair is growing faster and has higher margins, as mentioned before. A well-written piece of Easyjet's past long-term performance can be found here on Seeking Alpha.
The second factor is given by a series of events that impacted Easyjet's share price during last year: a weak pound following Brexit and a series of large disruptions due to terrorist attacks caused the company's profits to decrease by 30% with respect to the year before, which in turn almost halved its market capitalization in sterling (for mainland and overseas investors the drop was around 58%). The table below shows revenues ad before tax income. The company estimated that the exceptional disruptions caused by terrorist attacks and similar events in Paris, Nice, Brussels, Egypt, and Turkey plus immediate effects of the Brexit cost it GBP 150M, while currency headwinds added another GBP 112 to the bill.
Profit before tax
Cost of disruptions
Costs due to averse exchange rates
EPS, fully diluted
Source: Easyjet Reports;
Easyjet's financial year ends in September, so its Q1 report is already available: the company foresees additional GBP 105B costs due to the low Pound in 2017. By looking at the above table it seems to assume a similar
Factors impacting the company's results
A closer look at the variables that brought down Easyjet's stock price reveals that the shares are oversold:
- Brexit: Brexit has been a shock for Europe and has introduced regulatory uncertainties ranging from landing rights to citizenship of owners and visas for leisure travelers. Easyjet is going after European air operating licenses to be sure that it can maintain its intra-EU routes, which will cost GBP 10M. Even though the exit talks between the EU and UK may lead to significant uncertainties over the short-term, it is important to remember that it is in the best interest of all parties involved that both British (such as Easyjet) and EU airlines (Ryanair) are able to continue operating in the way they have been up to now. Since airlines are working closely together with the Commission on how to replace the present legislation and decisions will be largely in the hands of technocrats, it seems to be rather improbable that the end results are going to be disruptive.
- Low Pound: the low Pound currently hurts Easyjet because 50% of its revenues are in Sterling while a much larger share of its expenses, such as fuel, are paid in Dollars and Euros. Investors outside of Britain also feel the direct impact of the low sterling on their position. On the other hand, an improvement of the value of the pound towards other currencies will have a strong positive impact.
- Economic consequences of the Brexit: investors fear that British citizens will travel less abroad because of the low Sterling and lower incomes due to an economic downturn in the UK. This is arguable because taking a low-cost flight to some nearby destination is still the cheapest way to go on holidays for UK tourists and the flight itself is not the most expensive part of the vacation. Also, lower outbound tourism could be compensated by more tourists visiting the UK because it becomes cheaper.
- Disruptions: terrorist attacks in Paris, Brussels, Nice, Egypt and unrest in Turkey have led to flight suspensions in 2016. It is impossible to predict whether the next years will lead to more of such events. Certain is, however, that security measures have been improved and people are aware of the risks.
- Fuel prices: fuel prices are a double sided sword. Low fuel prices lead to higher operating results in the short-term but in the mid-term, they also lead to more competition because legacy carriers are able to lower their prices and increase competitive pressure. Long-term, however, low-cost carriers are able to increase their market share because of their business model that is aimed at competing on cost.
Based on Easyjet's 2016 annual report, the results from Q1 and the points listed above, one can come up with the following estimates for 2017 without making too many assumptions:
- as a starting point, earnings before taxes in 2017 are going to be similar to 2016, i.e. GBP 495M;
- costs of disruptions from terrorist attacks are going to be GBP 50M instead of GBP 150M in 2016;
- costs for currency headwinds are going to be GBP 105M, as guided by management in Q1.
- additional costs, such as the EU licenses and the disposal of aircraft, as mentioned in Q1 add up to GBP 25M;
- the tough competitive environment in case of lower sustained fuel prices is compensated by capacity growth from the opening of new routes (9%) and cost savings on expenses other than fuel (2%).
These assumptions lead to earnings before profits of GBP 465M, or around GBP 400M in net results, provided the tax regime remains about the same. This would translate into a PE ratio somewhat higher than the one of 2016, but still under 10. Dividend yield would be above 4%. This estimate is more bullish than consensus, which is an indication that the variables involved may turn out to be volatile.
In Europe, Ryanair and Easyjet are more suitable long-term investments with respect to the legacy carriers. They are well-managed growth companies with a durable competitive advantage in a tough environment. Easyjet is valued lower because it is less aggressive in expanding its business and currently faces more challenges, which translate into a series of uncertainties during the next two years. At the current prices, they are probably both a good buy for long-term oriented value investors.
However, there are some subjective arguments that may lead long-term investors to prefer Easyjet. First, it pays a high dividend, while Ryanair engages in share buy-backs. Second, Ryanair's "low-cost no matter what" strategy leads to lower satisfaction among customers and employees: Easyjet leads in terms of passenger satisfaction among the two according to Skytrax (most readers who have tried both can probably confirm this) and it also leads on Glassdoor with a 3.9 employee rating with respect to Ryanair's 2.6.
Eventually, one word of caution: even though Berkshire recently bought into Airlines, we shouldn't fool ourselves into believing that the airline business has lost all of its troublesome characteristics Warren Buffet used to complain about in the past. As SA contributors Laurentian Research Lab point out, it might as well be that Berkshire's engagement in airlines will turn out to be not as long-term as its other investments.
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