Ryanair (RYA.I) – Cruising Altitude

(This is the twelfth installment in my series of case studies on the shares that make up my portfolio. To see the other eleven articles, on PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish Life & Permanent, Datalex, Trinity Mirror and Datong, click on the company names)

 

I have to admit that the biggest challenge I had when sitting down to write this blog was trying to come up with an angle that hasn’t already been flogged to death. Ryanair is one of the best followed Irish companies, with 22 brokers producing research on it, while with 76.4m passengers having flown with Europe’s biggest LCC in 2011, it’s also one of the best known Irish companies. It’s also one of the most divisive Irish companies, with opinion generally split between those for whom Ryanair can do no wrong (and who will tell you that Ryanair CEO Michael O’Leary should be put in charge of Ireland!) and those who will tell you that they’d rather swim in a tank full of hungry sharks than fly with it.

 

With this in mind, I decided to narrow my focus on Ryanair down to what I see as the four biggest issues currently facing the carrier – fuel, the economy, non-fuel costs and what it should do with its excess cash – and how it is addressing them. Tying these issues together, I’ll then look at Ryanair from a valuation perspective.

 

Fuel – This is by far the biggest cost item for Ryanair, accounting for 39% of total operating expenses (€1,227m out of €3,141m) in FY11 (Ryanair’s financial year end is March). In FY12, I forecast that the fuel bill will climb to €1.53bn (+25% yoy) before rising to €1.94bn in FY13 (+27% yoy). To illustrate the scale of this increase, the €0.7bn rise in the fuel bill between FY11 and FY13 roughly equates to Ryanair’s entire net income for FY10 and FY11 combined. Passing this increase on is going to be tricky, and I’ll look at that in the next section. However, on the positive side, Ryanair disclosed in its Q3 results in January that it is already 80% hedged for FY13 at circa $99/barrel, the certainty from which I assume has allowed the carrier to take early action to manage pricing and capacity.

 

The Economy – I don’t want to come across as being all Captain Obvious with you, but clearly, the challenging economic conditions in many of Ryanair’s key markets is a headwind for the carrier. Ryanair is meeting this challenge in a number of ways. For starters, it has redeployed a lot of its capacity, adding more routes in Southern Europe while cutting back in Northern Europe. This has no doubt contributed to the well-documented problems a lot of tour operators have been facing in recent times. Secondly, the demise of a number of Ryanair’s competitors, such as Spanair and Malev (which collectively flew nearly 22m passengers in 2011), has helped to ease competitive pressures and facilitate price increases. On this point, in FY10 Ryanair’s average total revenue per passenger was €44.93. In FY11 it had increased to €50.34 while I estimate that it increased to €55.61 in FY12. Thirdly, Ryanair has been grounding an unusually (by its standards) high proportion of capacity during quieter periods. Last winter Ryanair grounded 80 aircraft (around 30% of its fleet), which both saves on costs and allows the carrier to nudge up fares even further.

 

Non-Fuel Costs – Having squashed these for many years, I see downside pressure to Ryanair from a number of these. The average age of Ryanair’s fleet of aircraft has increased from 2.77 years in FY09 to “just over three years” in FY11. With the lack of a new fleet deal and a busy order book for Boeing suggesting that Ryanair isn’t going to get a sweetheart deal for new aircraft anytime soon, this means that the average age of its fleet will likely continue to trend higher. This will put pressure on Ryanair’s maintenance costs going forward. Staff costs rose 20% to €376m between FY09 and FY11 as the carrier  expanded its operations, with the average number of passengers / employee falling only marginally from 9,195 to 8,942 over the same period. Given Ryanair’s proven form for ruthless cost management, I wonder if circa 9,000 passengers / employee is as low as they can get it down to. If so, costs will track higher as passenger numbers increase. Where Ryanair may be able to make progress against costs are in the areas of Aircraft & Handling Charges and Route Charges, and time will tell as to the extent competition from cheaper Eastern and Southern European airports for its custom will offset rising charges at a number of Northern and Western European airports.

 

Excess Cash – One big thing that Ryanair has going for itself is its prudent balance sheet policy. With net debt / EBITDA consistently staying below 1x (I estimate that it will be 0.5x in FY12), the carrier has a lot of financial flexibility. It has been returning cash to shareholders of late, paying a €500m special dividend in FY11 and spending circa €471m on buying back its shares since FY08. With a large-scale fleet deal seemingly some years off, speculation is rising that one, and possibly two, further €500m special dividends are on the way. I forecast that the first of these will be paid later in this calendar year (i.e. in “FY13”) and a second one in FY14. Based on last night’s closing price (€4.195) these represent a combined dividend yield of 16% over the next 18 months or so. Ryanair bought back circa €40m worth of its own shares earlier this month, and given management comments on the conference call that followed its recent Q3 results I wouldn’t bet against further buybacks in the not too distant future, which should help to act as a support for the share price.

 

Bringing these all together, it’s clear that there are plenty of things for the glass half-full brigade to use to put together a bullish investment case (easing competitive pressures as high fuel prices put rivals out of business, share buybacks, special dividend), while the glass half-empty ones can just as easily put together a bearish investment case (fuel, weak consumer, rising non-fuel costs). Like I said at the top of this piece, it’s a divisive company!

 

Looking beyond the current confusion, in terms of my more longer-term valuation approach I use a blended methodology incorporating: (i) a DCF, with my standard 10% discount rate and a 2% terminal growth rate; and (ii) a SOTP, based on 15x the average EPS I forecast for the next 2 years and then adding on the current market value of Ryanair’s shares in Aer Lingus (interestingly, Ryanair’s stake is currently worth €159m, which is 40% higher than the book value reported in the FY11 accounts). These produce valuations of €5.09 and €4.79 respectively, making for a blended price target of €4.94, which represents 18% upside to last night’s closing share price.

 

Stress-testing these valuations produces some interesting results. If I cut my terminal growth rate in my DCF to zero, this gives a valuation of €4.199, which is more or less bang in line with last night’s closing price. Similarly, if you cut the PE multiple used in the SOTP to 11x, you get a valuation of €3.54 a share. Adding in the €0.675 of distributions / share my forecast two special dividends over the next 18 months gets you to last night’s closing price. To look at it this way, is Europe’s biggest low cost carrier with a successful strategy of cost leadership and a strong balance sheet worth more than 11x earnings at a time when profits are under such an intense attack from a combination of high oil prices and severe economic fragility and many of its peers are slashing capacity and/or exiting the market? I would have thought so.

 

In all, I’m comfortable with my €4.94 price target. While markets look set for a spot of turbulence in the short term, Ryanair’s proven resilience in the face of challenging economic conditions and near term supports in the shape of at least one special dividend and the potential for further share buybacks means that I’m happy to fasten my seatbelt and stay on the share register.