| 2019 | 2020 | ||||||
| Price: | 8.87 | EPS | 0.71 | 0 | |||
| Shares Out. (in M): | 1 | P/E | 12.0x | 0 | |||
| Market Cap (in $M): | 9,900 | P/FCF | 8.4x | 0 | |||
| Net Debt (in $M): | 800 | EBIT | 1,061 | 0 | |||
| TEV (in $M): | 10,700 | TEV/EBIT | 10.0x | 0 | |||
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Investment thesis
Ryanair is currently hit by substantial uncertainty at several levels:
Individually, any of these factors would result in significant pressure on Ryanair’s share price. Collectively, they have resulted in a tsunami-like situation with Ryanair trading at historic lows:
While the uncertainties are material, they all (expect for unionisation, which will be discussed in more detail below) are shorter-term in nature. More importantly, Ryanair has sustainable competitive advantages in a large and structurally growing market (low-cost aviation) and is led by a management team which is shareholder friendly and has an outstanding track-record built over more than two decades. The current valuation implies that the present uncertainty will go on in perpetuity and does not recognise the sustainable competitive advantages possessed by Ryanair.
As I will discuss, the factors leading to the current depressed valuation may take years to disappear but once they do, Ryanair is ideally positioned to emerge as the long-term winner and key beneficiary in European aviation. In my view, at the current the valuation of Ryanair therefore represents an attractive long-term investment.
Ryanair has been written up a couple of times on VIC, most recently in 2016 by Hal. What has changed since then? The share price has almost halved while Ryanair has extended its cost advantage and increased its earnings power. I will touch on these points below but first I will start off outlining the key dynamics in the European airline industry.
Industry dynamics
The airline industry is often dismissed in value investing communities – and for good reasons: It has commodity-like characteristics, low barriers to entry, low margins with a largely fixed-cost base and is capital intensive. As Warren Buffett noted in 1988:
“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.”
However, even Warren Buffett has changed his view on the industry and is now a major investor (he has owned ~10% of each of the four major US airlines since 2016). What changed for Buffett between 1988 and 2016? Consolidation. In 2004, the five largest airline groups in the US had a combined market share of 66%. Primarily as a result of M&A, this has increased to 86% in 2018. The result is more rational pricing and improved economics for the industry.
The European market is broadly comparable to the US market in terms of size (seats flown in 2018 was 944m in Europe vs 968m in the US). However, Europe remains significantly more fragmented with the five largest airline groups having a combined market share of 62% in 2018 (vs 86% in the US). Interestingly though, Europe has consolidated at a similar pace as the US (~20 percentage points over the period 2004-18) but started from a lower base (38% in Europe vs 66% in the US).
The high fragmentation, excess capacity and resulting low fares has led to a long list of bankruptcies in Europe in recent years, e.g. Germania (2019), flybmi (2019), Flybe (2019), Small Planet Airlines (2018), Cello (2018), Cobalt Air (2018), Primera Air (2018), Azuz Air (2018), SkyWork (2018), VLM (2018), Monarch (2017), Air Berlin (2017) and Alitalia (2017), to name a few. In addition, a long list of larger carriers are known to be on the fence, e.g. Norwegian, Thomas Cook, 2e, LOT, TAP. This supports the view that continued consolidation in Europe looks inevitable. Michael O’Leary (CEO, Ryanair) also made this point at Ryanair’s earnings call in May 2019:
“The North American industry, having fully consolidated into 4 major carriers, is in a much better shape than the European industry is at the moment. We are going through these painful throes while the industry consolidates, and we just have to deal with it as best as we can. (…) In that consolidated outcome, there will be fewer players. There will be more - well, I would say, capacity growth over the medium term and much more pricing power. Airfares in Europe are materially lower than they are in North America and with a higher cost base. That will, over the medium term, work its way out of the system. (…) It is clear in my mind that within the next 4 to 5 years, you are seeing the emergence of 4 or 5 large European airline groups.”
The continued European consolidation towards 4-5 players will have important implications for the winning airlines as it will reduce excess capacity and increase pricing power – similar to what happened in the US. Now, what will be Ryanair’s role in an industry that consolidates to 4-5 larger players?
Business model
Ryanair’s business model is well known and can be summed up with the description below from Michael O’Leary (from the book A Life in Full Flight):
“We have the lowest cost base of any airline in Europe. Business is simple. You buy it for this, you sell it for that, and the bit in the middle is ultimately your profit or loss. We have low-cost aircraft, low-cost airport deals, we don’t provide frills, we pay travel agents less, our people are well paid but work hard and we deal in efficiencies.”
Ryanair has demonstrated over the last two decades that low-cost works, having not only grown to become Europe’s largest airline in terms of seats flown but, more importantly, having done so profitably. Ryanair’s business model is simple and continued success rests two key pillars: (i) its ability to remain the lowest cost airline and (ii) its ability to continue growing. These two pillars will be discussed in turn.
Cost advantage
Warren Buffett in the 2001 Berkshire Hathaway shareholder meeting highlighted the importance of cost in the airline industry: “You can’t take labour costs that are materially higher than your competitor in a business that has commodity-like characteristics such as airline seats, you just can’t do it over time. You can get away with it for a while but sooner or later the nature of a capitalist society is that the guy with a lower cost comes in and kills you.”
Ryanair competes with both legacy carriers (e.g. Lufthansa, IAG, KLM) and other low-cost airlines (easyJet, WizzAir, Eurowings). Legacy carriers have cost bases which are 2-3x higher than Ryanair, resulting in correspondingly higher ticket prices. Legacy carriers have, so far unsuccessfully, tried to launch their own lost-cost airlines. Lufthansa is currently trying to aggressively push its low-cost airline (Eurowings) in the DACH region, but at a significant loss. The threat from legacy carriers in terms of competing on cost appears non-existing.
Comparing with the other low-cost airlines, Ryanair has ex-fuel CASK (cost per available seat kilometre) of €2.31 cents, compared to Wizz Air of €2.24 cents (-3% vs Ryanair), easyJet of €4.58 cents (+98% vs Ryanair) and Eurowings of €5.70 cents (+147%). It is worth noting that Ryanair’s CASK jumped ~10% in 2019 due to integration of loss-making acquisition (Laudamotion) and higher staff cost. In 2018, Ryanair’s CASK was €2.09 which was 8% lower than Wizz Air. It is also worth noting that the cost difference in CASK between Ryanair and all other low-cost carriers has been constant as far back as data is available.
Looking at the individual cost lines is instructive to understand where Ryanair’s cost advantage arises. The analysis below looks at easyJet which is the low-cost competitor with most overlap in network.
Looking at the numbers, it appears evident that Ryanair has a significant cost advantage versus competitors. The former Head of Costs at easyJet explained Ryanair’s cost advantage in an interview in November 2018:
“What they [Ryanair] will do is they will go wing kit to wing kit, leveraging their cost advantage. You might see it’s actually been happening between Luton and Copenhagen relatively recently. That’s the greatest threat for EasyJet as I see it, is just the slow creep, airport by airport, of Ryanair moving from their non-regulated airports into the airport regulated space where EasyJet has the cost advantage over the legacy carriers and Ryanair has traditionally avoided those airports, Ryanair is moving into them now. Ryanair is quite capable of an acquisition and if they make an acquisition then suddenly the press would appear in a particular place or in a particular section of the network. In the meantime, it’s going to be kind of piecemeal, or death by a thousand cuts you might say. (…) They have an underlying structural cost problem or disadvantage against Ryanair.”
Ryanair has a clear cost advantage built over decades, due to (i) economies of scale (i.e. being the largest airline in Europe by passenger numbers), (ii) no-frills business model focused on high traffic and low aircraft turnaround time with a uniform fleet, and (iii) culture driven by cost obsession. It is the sum of a lot of smaller advantages. During the last two decades, no legacy carrier or low-cost carrier has managed to even come close to replicating Ryanair’s cost advantage.
The exception that confirms the rule is Wizz Air. Ryanair’s limited presence in Eastern Europe meant prices were high, allowing a new low-cost operator like Wizz Air to enter and quickly gain market share from legacy carriers. In a way, Wizz Air’s rise confirms the strength of Ryanair’s business model: It was the absence of Ryanair which opened the door for a new low-cost carrier. However, Ryanair’s dominant position in the rest of Europe deems it impossible for a new low-cost competitor to come in at a price point below Ryanair in the large markets.
Size of opportunity
Ryanair’s explosive growth over the last two decades to become Europe’s largest airline carrying almost 150 million guests raises the question: how much is left to go for? As outlined below, several factors support a long remaining runway (pun intended) for organic and inorganic growth.
Organic growth
Current fleet comprises 431 aircrafts and Ryanair expects this to increase to 585 aircraft by 2024 (combination of confirmed orders, option contracts and expected disposals). This will drive number of passengers from ~150 million to ~200 million in 2024. This target was most recently confirmed by Michael O’Leary in a July 2019 earnings call:
“I've seen some analysts out there, usually on the sell side, "Oh, the 200 million won't be met." I see no reason why the 200 million won't be met by 2024. But obviously, it is contingent upon the MAX delivery happening. I think the reason why I would disagree, I know Bernstein, for example, were quite negative on the 200 million. I mean, the bit that they have factored out is who's going to go bust this winter, and that will fundamentally change and alter the dynamic of traffic growth in the next number of years. I continue to be strongly of the view that by 2024, there will be 4 very large airlines in Europe.”
As described, continued consolidation in Europe looks inevitable and consequently Ryanair is ideally positioned to replace the capacity that will be taken out of the market.
Aggressively pursuing market share gains in large but relatively untapped markets is another significant opportunity. Almost 70% of Ryanair’s revenues come from the UK (19% market share), Italy (27%), Spain (20%) and Ireland (49%). Large untapped opportunities exist in Germany (9% market share), France (7%) and CEE (14%). In these markets, Ryanair competes mainly with legacy carriers with significantly higher cost bases. As has been the case historically, Ryanair is likely to creep into these markets, city-by-city, airport-by-airport, replacing legacy carriers. This process can be accelerated by factors putting pressure on the comparatively low margins for legacy carriers – e.g. an economic downturn, accelerated price pressure or rising fuel costs. This would eat into Ryanair’s profitability short term but accelerate the consolidation which is favourable for Ryanair in the long term. Again, Michael O’Leary explains this very clearly in May 2019 earnings call:
“So we can afford to lose money in the German market for a number of years without even having a major impact on our bottom line. Lufthansa, by contrast, reports a swing in Q1 from a profit of $50 million to a loss of $350 million. So we would say to Lufthansa, "Keep it up, lads." If you want to keep losing a couple of billion a year, sure, at below-cost selling, then frankly, keep going and we'll keep going and we will outlast Lufthansa because it doesn't -- it's not a huge part of our overall marketplace. They have a paranoid view that they need to control Germany, Austria, the entire Central Europe. That's their strategy and that's fine. But they don't have a low-cost operation. They never will have a low-cost operation.”
Lufthansa’s low-cost airline, Eurowings, lost €275 million during the last year. In Q1 2019 alone, Lufthansa lost €350 million, down nearly €400 million vs Q1 2018, and the share price is being hammered (down more than 50% since beginning of 2018). With net debt of more than €6 billion, Lufthansa cannot subsidise Eurowings forever. Germany is the most visible illustration, but similar dynamics can be seen in other markets where Ryanair competes with legacy carriers. This, together with the continued pressure on the large airlines mentioned above on the brink of bankruptcy (e.g. Norwegian, Thomas Cook) should fuel Ryanair’s organic growth ambitions in years to come.
Inorganic growth
Ryanair recently started opportunistically pursuing acquisition opportunities to get landing slots in slot-constrained airports. So far, two acquisitions have been made – Laudamotion (January 2019) and Malta Air (June 2019). The acquired companies will be part of Ryanair Group which now comprises four airlines: Ryanair, Ryanair Buzz, Laudamotion and Malta Air. Each airline will be competing against each other. Growth by opportunistic acquisitions can accelerate growth by giving access to new airports and it seems like a sound strategy in light of the ongoing shakeout in the industry.
Interestingly, Ryanair making acquisitions is also where Shane O'Doherty (former Head of Cost at easyJet) sees the main threat from Ryanair:
“If Ryanair actually makes an acquisition, that’s where the most pressure will come for EasyJet. Ryanair appears to be slowly but surely creeping into the EasyJet network that they would have avoided in the past. I think it’s going to come from Ryanair and I think it’s inevitable. I don’t think that they have a real response other than updating the aircraft. They might even have their head in the sand a little bit with it.”
Management
Michael O’Leary is obviously a key individual at Ryanair, having led the transformation of Ryanair from a small Irish carrier to the largest and most profitable airline in Europe. In addition to an outstanding track-record, Michael O’Leary and the rest of the management team stands out on several other parameters as well:
Earnings power
As mentioned in the beginning, Ryanair is currently facing headwinds from several factors, leading to depressed earnings. These include:
These factors combined led to 2019 EBITDA being significantly lower at ~€1.8 billion (22% margin) vs ~€2.2 billion in 2018 (31% margin). The calculation below helps to understand Ryanair’s true current earnings power:
Bringing historical load / yield factors and cost / margins in line with historical averages adds €700-900 million to earnings. On this basis, EBITDA could reach €2.6 billion. Importantly, given that this is based on historical figures it does not factor in the potential for continued European consolidation.
FCF and ROIC
When assessing Ryanair’s ability to generate free cash flow, it is important to distinguish between maintenance and expansion capex. For example, consider the following periods:
Maintenance capex can thus be assumed to be around 6% sales, as seen in the period 2012-13. Two natural questions follow from this: (i) what is the yield on Ryanair’s existing fleet in a run-off scenario and (ii) what does historical return on invested capital say about expected return on future capex?
Yield on existing fleet
Based on the “normal” EBITDA of €2.6 billion calculated above, maintenance capex at 6% of sales and a 12.5% tax rate, recurring free cash flow would amount to ~€1.9 per year, representing a 20% yield on Ryanair’s current equity value. Note that NWC is ignored for the purposes of this calculation (although it has been a major source of cash inflows as Ryanair has grown). How long would Ryanair be able to sustain these cash flows? With an average age of 7 years, assume Ryanair’s fleet can operate for another 5 years at which point the aircrafts could be sold.
Even in a continued unfavourable trading environment where Ryanair keeps generating €1.8 billion of EBITDA, free cash flow would be €1.2 billion or a 12% yield on current equity value.
ROIC
Ryanair has ambitious growth plans – it is committed to increasing passenger numbers from 142 million in 2019 to 200 million in 2024 (7% CAGR) – so the analysis above is theoretical as a lot of the free cash flow will be re-invested into new aircrafts to facilitate growth.
ROIC in 2019 was 19%, significantly below the 5-year (2014-18) average of 27% and in line with 10-year (2009-18) average of 20%.
Ryanair has historically re-invested 70% of its operating cash flows back into the business. Given the opportunity to continue growing across Europe (as outlined above), Ryanair should be able to continue re-investing a significant portion of its free cash flow at attractive ROIC.
For the purposes of this analysis, assume Ryanair can re-invest 50% of free cash flow at a 20% ROIC in the coming five years. Assuming year 0 free cash flow of €1.9 billion of which 50% is re-invested each year and compounds at a 20% ROIC, free cash flow after five years would be €3.1 billion and cumulative free cash flows would be almost €15 billion.
Valuation
At €8.87 per share, Ryanair’s equity value stands at €9.9 billion. With net debt of just €0.8 billion (including operating leases), enterprise value stands at €10.7 billion. In terms of multiples, this represents 10.0x LTM EBIT, 6.1x LTM EBITDA and 8.4x EBITDA minus maintenance capex. On an adjusted basis (using the metrics described under earnings power), the multiples drop to 4.0x EBITDA and 4.9x EBITDA minus maintenance capex.
Applying free cash flow of ~€1.9 calculated above and assuming a 10% discount rate, the current valuation implies negative growth rate of 8% in perpetuity.
A DCF valuation with a 10% discount rate and assuming Ryanair continues expanding capacity based on committed order and metrics (ticket RPK and CASK) converge towards long-term historical levels would imply a share price of €16, almost double the current share price.
Downside Risks
Below is a list of the key identified risks and where this analysis could be wrong, including why I believe these risks are either not detrimental or are shorter-term in nature.
Where the market is wrong
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