Description

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

I have a “one problem policy”.  That is, I do not invest in companies with more than one problem, because I found that problems tend to compound and exponentially erode the margin of safety.

 Unfortunately, Wizz has more than one problem:

1.      It has too much leverage.

2.      It is suffering from the Pratt & Whitney engine issues.  Consequently, ~20% of the fleet is grounded and the issue is expected to persist over the next 2 years.

3.      The company took on expensive wet leases which are weighing on earnings.

4.      While not technically a problem, the company is an airline, which means that wars, pandemics or even the occasional recession, can have a disproportionate impact.

So why write up a company with little margin of safety?  First, the wet leases go away this month (October).  Next, before the company realized how expensive these leases are going to be, management guided for €500M-€600M in net income for this year (since then the figure has come down, mostly because of the temporary wet leases).  Adjusting for FD share count (including convertible / SBC / etc.), The company has a market cap of £1.6B (which translates to €1.9B).  So, we get to buy this business for 3-4x net earnings, excluding the temporary issue that goes away this month (but still including the medium-term issues of engine problems that will also go away in 2 years). 

Trading at this PE, you’d think Wizz is a dying business, but in fact it grew fast in the past decade and should again grow 15-20% / year at least in the next 5-7 years just based on the capacity it adds.

While this is a highly levered company, I will argue that the upside is up to 8x from these levels and possibly more.  Given the nature of this risk / reward I would size it as a leveraged equity stub / LEAP (taking a page of Greenblat’s “You Can Be a Stock Market Genius”).

Introduction:

Wizz is the lowest cost airline in Europe.  Yes, even lower cost than Ryanair.  In addition, while it gets a mere two-star rating on Tripadvisor, customers tend to be fans.  Customers get Ryanair prices at EasyJet comfort.  The negative reviews are mostly from people who do not meticulously follow the airline rules, which result in extra costs (check in online and not in person, don’t assume they’ll let you bring in a slightly bigger / heavier bag for free, don’t expect free water and so on).

Wizz’s competitive advantage is in hiring lower cost Eastern European un-unionized staff.  In addition, Wizz is growing very fast and as a result has much newer planes than anyone else. This translates into better fuel economy and more passengers per plane (which means lower fuel CASK).  As a result, Wizz has the lowest CASK in the EU (up to 20% lower than Ryanair’s).

Pre COVID, Wizz had a pristine balance sheet, but then, in the aftermath of the pandemic, the company chose not to dilute shareholders.  Instead, it took on debt and completed sale and lease back transactions, which helped it survive the pandemic without dilution.  This preference of leverage over dilution is unsurprising because the company is controlled by Indigo (the same PE firm that started Frontier, Volaris and other ULCC).

Over the years the company has been growing fast and it currently has 210 aircraft (but only 169 operating ones, because of the engine issues – more on this later).  This is up from 50 aircraft in 2015, and the plan is to grow to 450 planes by 2030 and 500 by 2032.

Balance Sheet:

The company has €1.7B of cash and €6.6B of total debt.  About €1B of the debt is secured / unsecured debt and the rest is lease liabilities.  As a side note, I treat lease liabilities as debt for the purpose of this write up.  The company has been paying down its secured / unsecured debt and is expected to continue doing that.  Management guided to continued debt pay down, while over the longer term, as credit rating improves, it may start buying planes outright.

The company has been using Indigo’s purchasing power to buy planes and engines at a substantial discount (it’s the buying power of 4 airlines combined).  Then, post purchase, Wizz does a sale and leaseback transaction to realize the discount.  This income source is not temporary / low quality earnings but rather a permanent fixture that will remain for as long as the company continues growing (and to a lesser degree when it maintains its size and simply buys planes / engines to replace the maturing fleet).

Debt / EBITDA ratio is currently high at 3.9x, but if the company keeps paying down debt, grow the business and get over the temporary setbacks, this ratio will collapse (even with all the expected growth in planes) to below 3x in 18 months and to ~2x the year after.

When this is achieved, the company can start considering owning planes outright. 

Note that I don’t like using Debt / EBITDA for the reasons Munger always mentioned, but I mention it here because this is how the credit rating agencies will look at it.

Engine issues:

The well-known issues with Pratt & Whitney (P&W) engines caused Wizz to ground roughly 50 planes.  For each engine, there’s a wait time to get an available shop and then it takes 300 days to fix the engine.  From the time the engine is fixed it takes a couple of weeks for the installation / tests before the plane can be put in service again.

P&W pays Wizz compensation for the grounded planes, but the compensation doesn’t include:

1.      The few weeks it takes from receiving the working engine and until the plane can be deployed.

2.      The profit the grounded planes would have made.

3.      The fact that less efficient planes are operating instead of the brand-new grounded ones (lower capacity / worse fuel economy).

As a result, the company is underearning and will continue to underearn until the last engine is fixed.  Currently, the plan is for the last engine to be sent to a shop in December 2025. Adding the 300 days of service take us to calendar Q3 2026.  There could be upside from this schedule:

1.      This schedule includes spare engine fixes, and the company could run with fewer spare engines for some time.

2.      Every shop that becomes available ahead of plans pulls the schedule forward. 

In any case, this issue is not going to be with Wizz 2 years from now. 

When the company reported earnings in August, 45 planes were grounded and management expected that the peak grounding will be 47 planes in September.  According to the October 2nd Capital Markets Day, the range in 2025-2026 will be 40-45 (lower than the previously expected 50). This figure gets diluted as the fleet grows on average 15% / year through 2030.  So safe to say that the impact is gone in 2 years and has already peeked at 20% of planes and will only go down from here.

Management:

Management lost all credibility with the market when, on the August 1st report they lowered fiscal 2025 (ending March 2025) net income to €350M-€450M. This was down from the €500M-€600M guidance they issued on May 23rd of this year (a mere 60 days earlier).  

The bulk of the drop was blamed on the wet leases that the company took to “protect the summer” from competitors.  As more planes than expected had to be grounded, management took short-term, highly expensive wet leases.

I don’t know that the decision to take expensive leases was bad.  It could be argued that it was smart of management to sacrifice short term profit so that they won’t have to cancel a large number of flights and lose customers’ confidence longer term.   I do think that the messaging to the market should have been much better and more conservative in a period with so many unknowns.

Since then, the company brought in an IR director who was a ULCC sell side analyst and will probably help formulate the messages better going forward.

Overall, it’s hard to ignore the fact that management created a fantastic business with competitive advantages and a long-term growth trajectory.  The CEO co-founded the company in 2003 and has been the CEO ever since.  Obviously COVID represented a major setback for airlines, but between the IPO and COVID, the company attracted an average PE of x14, which demonstrates the market’s confidence in the business.  Besides the balance sheet, I don’t believe anything is fundamentally different in the business today.

Another contentious topic is the CEO pay package.  He was set to receive up to €100M in stock if the shares hit £119 by 2030.  On a sliding scale, if stock hits £77, then he would get €20M and below a share price of £77 he gets nothing from this package.  I don’t have any problem with the CEO getting paid if I get a 7-10x return in 6 years, but I know some had a problem with that so flagging it (plus, the original plan “only” factored in a 2-3x in 7 years).

Valuation:

Without the wet leases issue, the company would likely be making €500M-€600M this year, which puts the PE at 3-4x.  Looking 3 years forward, with the engine issues behind us, lower debt and bigger business (assuming 320 planes per their Capital Markets Day), I’d expect the company to generate an EPS of €5-€8, depending how competitive the market is.  A 10-12x earnings multiple would be low historically, would be low for a business that grows 20% / year and would be comparable to Ryanair’s current PE even though WIZZ grows much faster and has lower costs. This PE range would put the target price in the range of £42-£80 (note the conversion from EPS in € to stock price in £).  This is 250-700% higher than current prices.  This framework uses an EBIT / plane ratio that is much lower than the pre-COVID levels.  If we take the pre COVID average of 4.75M EBIT / plane, EPS would be €10 and at a PE of 14x (pre-COVID average) the target price is £117 or ~10x return on the current share price.

Another way of looking at valuation is by comparing Wizz to Ryanair.  By 2030-2032, Wizz will have a comparable size of business to that Ryanair will have, but Wizz is just 1/10 of the Ryanair market cap (90% lower!).  True that Ryanair has a better balance sheet, but by then I’d expect WIZZ to pay off debt / lease and own more of its planes as in the pre-COVID days.

Risks:

1.      Leverage.  This is why it’s an equity stub type investment and should be sized accordingly.  If the future goes as planned, the company will pay down debt significantly while materially increasing its earnings power.

2.      Seat supply.  Both Wizz and Ryanair add 300 planes each.  Wizz will be adding them until 2032 while Ryanair, suffering from OEM manufacturing delays, is unlikely to grow materially in the next 5 years.  In addition, Ryanair has older planes, so some of the 300 will be used to replace existing ones.  In any case, the addition of 500-600 planes to Europe is basically like adding another Ryanair, so this is a concern in terms of the competitive environment.
I expect some of the supply to be absorbed at the expense of the legacy carriers (no one besides Wizz and Ryanair really grows the fleet; easyJet grows by a small amount too, but not substantially).
In addition, Eastern Europe (Wizz’s main market) per capita travel is still well below Western Europe, while at the same time Eastern Europe has the fastest growing GDP in the EU.  For example, Hungary / Poland GDP per capita was 1/4 that of Italy in 2007 and now is more than 1/2.  If GDP catches up, travel per capita will too.  This will absorb a lot of the demand.
(See here a graph that shows how travel per capita is highly correlated to GDP per capita).
Finally, uncharacteristic of ULCC, Wizz is opening 8-9 hour flights to Persian Gulf destinations.  This is another booming area that likely can absorb more seats.

3.      An expansion of the Ukraine war to additional fronts will significantly hurt Wizz (an Eastern European focused airline).

4.      The EU shooting themselves in the foot one more time with “Fit for 55” environmental agenda.  Don’t know how to assess the impact, but Wizz is the cleanest airline, and it does have a large base in Eastern Europe / Middle East, so will be better than even Ryanair (which again, has a ~10x larger market cap).

5.      Violation of the “one problem policy”.  Surprise issues can push Wizz over the edge. 

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Catalyst

Wet leases go away this month.

Engines getting fixed over the next 2 years.

Debt paydown accrues to equity, because EV is like 3/4 debt.

Management hopefully regains market confidence after demonstrating consistent execution and earnings.