|Shares Out. (in M):||1,243||P/E||12.6||13.2|
|Market Cap (in $M):||17,690||P/FCF||20.9||36.6|
|Net Debt (in $M):||151||EBIT||1||1|
|TEV (in $M):||17||TEV/EBIT||11.5||11.9|
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The genesis of this idea came from a talk and Q&A session given by Michael O’Leary the CEO of Ryanair which we attended. We came away deeply impressed by O’Leary and the business he has built.
Among the things which most impressed were the CEO’s enthusiasm and energy for the business, ambition not to rest on his laurels, his focus on every detail that will make it successful (primarily on every cost), his command of the key numbers in the business (not the financial numbers though he knew those, but also the underlying unit economics such as cost per check-in desk at Stansted etc.) and his humility in not taking himself too seriously.
However, a business with poor underlying economics even with superior management usually only delivers, at best, mediocre results for investors. The airline industry has a long track record of delivering subpar returns as a consequence of selling a largely commoditised service that requires large upfront capital expenditures, has high fixed operating costs and minimal marginal costs for flying one more additional passenger. This toxic combination leads to an absence of pricing power as airlines fight each other with price cuts to attract the marginal flyers to try and cover their sunk costs. As Warren Buffett is often quoted as saying:
“Durable competitive advantage in the airline industry has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down. The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit.” – Warren Buffett
In contrast to this, Ryanair’s impressive long-term financial track record and the cash it has generated for shareholders suggested that Ryanair must also be benefiting from competitive advantages in addition to having superior management. Intrigued we decided to investigate further.
In its early days, Ryanair was itself loss making. In order to try and turn it around, in 1992 Michael O’Leary visited Herb Kelleher the founder and CEO of Southwest airlines who pioneered the low cost airline business model:
“Michael O’Leary had spent 2 days studying Southwest’s operations from the ground and had begun to understand what made it work. Where other airlines took an hour and a half or longer to turn their planes around, Southwest did it in less than 30 minutes. He studied the check-in where passengers boarded quickly without seat numbers and he studied the prices the airline charged. It was obsessed about costs. It reduced staff training and maintenance costs by flying just one class of plane, it made them work harder by keeping them in the air longer. It was a model of controlled expansion, it did not rush and kept a tight lid on costs. O’Leary could see that it would work in Europe. The arithmetic could not have been simpler: keep your costs lower than anyone else’s, your planes working harder and your prices low and you could beat any competitor on any route.” – From the book “Michael O’Leary: A Life in Full Flight”
We dug deeper into Ryanair and its competitors’ cost structures to try and understand whether a moat built around cost advantage was likely to be sustainable in this industry.
Fuel is the largest single operating expense for airlines, accounting for c.40% of total costs. No long-term cost advantage can be achieved in buying fuel as airlines buy at a global market rate. ‘Route charges’ are another operating expense on which no advantage can be gained from superior buying power. These charges are set fees for which volume related discounts cannot be negotiated. Together oil and route charges make up c.50% of Ryanair’s cost structure.
The next largest costs for Ryanair are airport and ground handling charges. This is an area where Ryanair uses its scale to ruthlessly negotiate the best possible deal with the airports, who are keen to drive a flow of passengers through their shopping malls. During its early years Ryanair established routes at ‘secondary’ airports situated further away from urban centres. Ryanair has built up local dominant market share on these routes and has been able to negotiate aggressive terms with the airport owners.
The discounts and subsidies Ryanair receives are in the majority of cases linked to the volume of traffic the company delivers to an airport. The discounts typically range from a 30% to 50% of standard airport charges. In addition to discounts negotiated with airport owners it also wins subsidies from local governments in the form of marketing rebates. Combined, we estimate these discounts and subsidies are worth on average €1.9m per airport. With Ryanair currently flying to 190 airports across Europe, these in total are worth €360m, representing c.25% of the company’s 2016 operating profit. The company is in a strong negotiating position with airports given the glut of runways in Europe partly as a consequence of the cold war. Airport owners know that Ryanair is in a position to walk away from an airport if it raises charges and open up a service at another runway in close proximity – something it has done consistently through its history.
“For O’Leary route dominance mattered, it gave him extra power with the airports served by his airline, and it gave customers in search of a cheap ticket no option but to choose Ryanair. He wanted dominance on a route not so he could push up prices, but so he could have far greater control over the airports and their charges. The result would be higher profits, but they would come from squeezing his suppliers for extra savings and from boosting passenger numbers, not from raising ticket prices” – From the book “Michael O’Leary: A Life in Full Flight”
“We will not enter a route if we cannot break even in three hours and grow the market by at least 100 per cent” – Michael O’Leary
The subsidies received from local governments are an area of potential concern. The European Commission has brought a number of cases against Ryanair accusing it of receiving illegal state aid. However, of the 12 cases brought against Ryanair since 2002 Ryanair has won all of them apart from two which it is in the process of appealing. The total possible exposure from these two airports, neither of which the company continues to fly to, is €12m. The company’s principal defences on which it has won its cases are that the subsidies it receives are compatible with EC Treaty decisions and the ‘Market Economy Investor Principle’ which holds that an investment made by a public entity that would have been made on the same basis by a private entity does not constitute state aid.
The next largest components of the cost structure are depreciation and maintenance charges which when combined represent c.10% of Ryanair’s costs. Here Ryanair uses its relative size advantage and ‘value’ orientated mind-set to negotiate advantageous pricing on aircraft and maintenance contracts. After the 9/11 terrorist attacks the global aviation industry was at a cyclical low. During this period Michael O’Leary played Boeing and Airbus off against each other to win discounts of 50-60% off the list price of Boeing 737s for an order of 150 aircrafts. This deal set the price bar with Boeing for future orders. There were market rumours that Ryanair was able to later sell some of these aircraft on in the second hand market for more than they purchased them for. More recently the company has placed orders for 383 new aircraft to be delivered over the period from 2015 to 2024. Ryanair’s tough negotiating style, the fact that it buys aircraft with a simplified fit-out (e.g. seats do not recline, there are no seat back pockets) plus its scale gives it buying power that none of its competitors can match.
Ryanair’s current fleet of planes has an entrenched advantage in that the Boeing 737-800 that it flies has 189 seats vs. an average of 164 seats per plane across EasyJet’s fleet of Airbus 320 aircraft. For high load factors this means that Ryanair is able to spread more paying passengers over the largely fixed costs of flying a plane. This advantage will reduce over the next decade as Ryanair and EasyJet begin to migrate to fleets of the next generation 737-MAX and A320neo respectively. However EasyJet will continue to be at a disadvantage with its A320neo planes having 186 seats vs. the 737-MAX’s 197.
Evidence to support cost advantage
There is abundant evidence to confirm Ryanair’s cost advantage:
1. Comparison of operating costs per passenger per kilometre
We analysed the operating expenses of Ryanair and its main competitors and compared them on a per passenger per kilometre basis adjusted for load factors. Excluding fuel costs Ryanair’s operating costs are c.25% and c.43% lower than its closest competitors Wizz Air and EasyJet respectively. When compared to Norwegian, Air Berlin and the legacy carriers such as Lufthansa, Air France-KLM and International Airlines Group (British Airways and Iberia) Ryanair’s operating costs are 50% to 70% lower.
2. Ticket prices
We collated and analysed ticket price data on 90 comparable ‘price points’ i.e. flights on the same route and at similar times on which Ryanair competes with EasyJet and Wizz Air. What we discovered was that Ryanair was cheaper on 88% of the flights, with a price on average 27% lower than its nearest competitor. On the flights where Ryanair was more expensive there was strong evidence that these flights were already nearly fully booked.
3. Commentary from competitors and industry players
The following quotes from competitors makes it clear that other players in the industry fully acknowledge that Ryanair has costs so low that they can’t compete.
In 2001 Go, British Airways low cost carrier which was later sold to EasyJet, decided to launch routes between Dublin-Edinburgh and Dublin-Prestwick. Go’s CEO Barbara Cassani wrote about the launch of the route:
‘But there was a big dark cloud with Ryanair written on it. Of course, we didn’t realise that Michael O’Leary would take the move as a personal affront. We had insider reports of him screaming and swearing a blue streak when he heard the news…It was general knowledge that they had promised no new routes from Dublin until their new airport deal was agreed and to avoid flying to BAA’s Edinburgh Airport until they lowered their charges. [But when he heard about Go opening the routes, he changed his approach]. “This is going to be a disaster for Go” he told the Irish Times “because the best they can manage is £45 as against our £29. Nobody will be flying with them except for the passengers they take off Aer Lingus.” Then he snorted that we didn’t even qualify as a low-cost airline. “Their fares are 60% higher than Ryanair’s and they have a crap schedule. Their first flight out is at 10am. We will be out and back at that stage. Goodbye Go” he taunted. We got a thrashing on the route as Ryanair slashed prices even further. Going head–to-head cost us millions and we withdrew wounded. We learned another crucial lesson about discounting. You can’t take on someone with lower costs because they dig deeper than you to lower their prices and still make money while you’re bleeding. There was no partial membership in the discounting game. We knew Ryanair’s costs were much lower but EasyJet’s weren’t…we could lower our costs below EasyJet’s within months if we restructured our schedule to use crew more productively, reduced selling costs using the internet, and took advantage of falling aircraft lease costs.’ – From the book “Go: An Airline Adventure”
“I find O’Leary scary, I don’t think anybody can compete with him especially as he is now focused on pleasing customers too.” – Chairman of competing airline
“Efficiency runs through their operations for example their operations team has 7 people in it compared to 17 at EasyJet which is a smaller business.” – Airline recruitment executive
We view growth as a component of value. We are willing to invest in growing businesses if we believe we can understand the durability of the business model and make a conservative estimation of future margins. We believe Ryanair fits into this category.
By 2024 the company plans to double the number of passengers it carries to c.200m from 91m in 2015, a growth rate of c. 9% p.a. This is in line with the planned growth in its fleet of aircraft, based on orders with Boeing. The question then arises as to whether this growth target is realistic. Several factors lead us to believe that it is. The first is that underlying airline passenger growth within Europe has been growing consistently for decades and is forecast to grow at 3.3% p.a. over the next 20 years. Secondly, there is a growing trend of primary airports in Europe suffering traffic declines as their incumbent carriers report losses and restructure. Legacy carriers are becoming less willing to subsidise loss making short haul flights as competition from Middle Eastern competitors puts pressure on their more profitable long haul operations. Many of these primary airports which are losing traffic from legacy carriers are beginning to incentivise Ryanair to open new routes/bases and deliver them traffic growth. We see this continuing especially in Central Europe, Germany, Italy, Spain and the UK. Germany in particular represents a significant growth opportunity with Ryanair’s market share currently at 4%, well below its 13% share of total inter Europe air passenger traffic. Given that in some markets, Ryanair has achieved in excess of 40% market share, we believe it is very realistic to model Ryanair continuing to increase market share to 17% by 2024.
Ryanair appears to be an unstoppable force in European short haul. It is the number one airline in most European markets and is gaining share in all of them. It has far and away the lowest cost structure and it is currently using this to price its tickets much lower than its competitors so it can gain share rapidly while also making a 25% post tax margin. The company is operating a similar strategy to that employed by the likes of Amazon and Costco in gaining market share by driving down prices but its cost advantage is so big that it can make attractive margins at the same time as implementing it.
The biggest risk we see with this investment is with Ryanair themselves. With successful companies there is always the risk that success gradually leads to them becoming ‘fat’ as they lose their laser like focus on costs. This is especially dangerous for companies such as Ryanair whose moats depend on them being the industry’s low cost provider. Having talked with the company and analysed trends in the company’s operating costs (which on a per passenger basis continue to decline) we don’t get any sense of complacency creeping in though it is something we will monitor closely for any signs of change.
“Michael just has to go on and on, succeeding and accumulating. It’s just the way he is. It’s too simplistic to say that it’s all a game; it’s far more serious than that. He makes money, and he succeeds, because that is what he does. There is no endgame, no point at which he steps aside and smells the roses. He is a perpetual motion, restless, insatiable, driven – but by what? Who knows? It’s just what he does, and it’s all he knows” – Former colleague of Michael O’Leary
Increase in oil prices putting further pressure on weaker competitors.
Market share gains in Germany.
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