Description

Note: Company reports in EUR, listed in GBP so the multiples in the mandatory VIC boxes above may come out wonky

They are an ultra low cost airline with a focus on Central and Eastern Europe (CEE). Broad backdrop of the investment case is that the company are in the early stages of what should be a Ryanair-like growth trajectory, with the company being the market leader in a very underpenetrated growth market, led by a capable, experienced management team who understand what is required to deliver shareholder value in this type of business, having done so before.

They are often competing against a weak state-owned incumbent or face no competition at all, and have the right strategy to achieve attractive returns on invested capital and earnings growth by having a uniform, cost efficient fleet of A320/A321s that allow them to enjoy CASK on a par with Ryanair and far below other LCCs and flag carriers, which allows them to charge low fares and still make money, taking share from higher-cost competitors and stimulating the market, creating a virtuous cycle of strong, profitable growth.

High level drivers: CEE Ex-Russia/Ukraine is ~135m people with a market size of ~60m seats; if you include Russia/Ukraine it is ~320m people with ~120m seats. Penetration in terms of seats/capita is thus ~0.45 ex-Russia/Ukraine, ~0.38 incl., vs. about 1.6 in Western Europe - both penetration and demand are obviously highly correlated to GDP per capita (see chart below), so given the overall faster GDP growth in the CEE countries (3.2% 2004-14 inc.), and the fast-rising propensity to travel linked to GDP per capita (seats per capita has grown from 0.065 in 2002 to 0.38 now), it should be realistic to expect the overall market to grow well above global GDP over the medium-term.

Other big picture driver is LCC very underpenetrated in CEE markets - it is about 21% across the region and 37% ex-Russia/Ukraine (see table below), vs. 35% in Western Europe.

Given the CEE consumer is likely to be more price sensitive, it is rational to assume that LCC will continue to take share over time given that the lower cost structure allows them to offer lower price. A typical example (taken from 23/02/16) would be Latvia - 2.6m seat market, 28% market share for LCC with government-owned and breakeven (previously heavily loss-making) Air Baltic at 56%. Direct one-way flight from London to Riga on 04/03/16 costs £126 on Air Baltic, £103 on BA, £46 on Ryanair, £25 on Wizz Air. The flag carriers can't compete on price because even at a cost 3x-5x as high, they are only at low single digit margins as they have an inefficient fleet and higher overheads - the overall CASK for Wizz would be ~3.68 EUR cents, only slightly above Ryanair (3.56) and well ahead of the LCC's (NAS 4.73, Easyjet 6.34) and the flag carriers (Air France, Lufthansa, IAG 9.13 on average).

It is rational to expect that the market will continue to grow over time and that they will take a bigger slice of it. The company have been positioning themselves for this dynamic, with a near exclusive focus on CEE and cost leadership, growing ASK from 19.3bn km in 2012 to 29.3bn in 2015 (with load factor up from 84.7% to 86.6%) while driving CASK ex-fuel lower. The growth in ASKs has seen the company take the top spot of the LCCs in CEE, with an aggregate share of 39%, ahead of Ryanair (30%) and Easyjet (7%). The growth has been profitable, with EBITDAR up from 146m in 2012 to 338m in 2015.

The long-term plan is to do more of the same, with the fleet expected to grow from 55 planes in 2015 to 67 by y/e 2016, up to 102 by the end of the decade and 152 by 2024. The company have a firm order with Airbus for the planes, which will all be the efficient A321/A320 models, ideal for short-haul flights; committed financing is already in place (they normally lease rather than own).

Assuming the company can keep load factors about flat from 2016 to 2020 (before the heavy capacity additions reduce it by a few points), the company should be able to grow their revenue from 1.23bn in 2015 to 1.43bn in 2016 all the way up to about 2.47bn by 2020. Ancillary revenue penetration has risen from 30% in 2012 to 38% in 2016 and should rise to well over 40% in the coming years as the company continues to execute on their plan of driving ancillaries/passenger by EUR1 per annum as they roll out reserved seating, priority boarding and other extras. Our assumptions on ASK growth, RSK growth and load factors are as follows:

In terms of how the company’s load factor has been holding up so far in the face of capacity expansion, it has been fairly resilient, which would somewhat validate the view that the capacity expansion is either creating new demand or is basically either low-risk “back filling” of existing routes or taking share from relatively helpless flag carriers:

It has been a similar trend industry-wide:

Source: UBS

The split between tickets and ancillary are as follows:

Other main drivers behind the revenue estimates (equivalent aircraft per period, departures per day, average seats, ticket prices, ancillary revenue per passenger, etc) are as follows:

If they can keep CASK inflation around the current trajectory and keep the load factors constant, this should drive EBITDAR from 338m in 2015 to 428m in 2016 all the way up to 610m in 2018; we see it at 780m by 2020. It is not unreasonable to expect that load factors can remain steady - competition is limited (no competition on 48% of 2014 capacity) and much of the capacity expansion is relatively low risk - only about 10% is new routes with 60% just increasing frequency on already successful routes and the other 30% back filling.

As the company takes delivery on the A321s, the ~10% fuel efficiency gains should help to keep the CASK under control (even allowing for some RASK dilution) and hence somewhat underpin our EBITDAR growth expectations. In terms of the CASK dynamics and what the key drivers are, the table below summarises our thinking:

At the risk of overkill with numbers, we put together the following EBITDAR bridges year by year to give a sense of where the delta comes from. It is mainly capacity increase, obviously, offset by associated cost rises with a slight load factor tailwind in the out years that might be a source of upside:

This is the easier to digest chart version out to 2018:

In terms of the valuation, it is not a clean value case and more of a GARP-type situation - one needs to be willing to look ~3 years out, but as the capacity gets added - assuming they can fill it and they can keep costs under control, a Ryanair-type EV/EBITDAR multiple would drive fair value comfortably above £28. The rough workings are as follows:

The dreaded DCF valuation (probably 99.9% useless in valuing airlines) assuming 9.9% WACC and 2.5% terminal growth implies it is at least a doubler:

Sensitivities to various growth and WACC assumptions is as follows:

You're investing alongside a successful team with Indigo, the controlling shareholder, having successfully invested in Tiger Airlines and Spirit Airlines, to name a couple, while the CEO and founder currently owns 2.8m shares, valuing his stake at EUR 65m - significant skin in the game.

Key investment positives are summarised as:

·         Overall growth backdrop is very supportive, with air travel low but rising, LCC penetration relatively low but rising

·         LCC looks to be the right model for CEE, with 70% of respondents claiming that cost is the most important decision factor

·         Positioned to meet that demand with CASK far below all but Ryanair, allowing them to take share, create demand via pricing

·         Company face no competition on a reasonable percentage of their routes, while they face easy comps on many of the others

·         Already very profitable (12% underlying margins) and value creation will become apparent as the company fill out capacity

·         Potential for them to deliver very strong earnings growth - 5Y EBITDAR CAGR to 2020 ~18%, driving 2020 EPS ~2.9 EUR

·         If they can come close to delivering, which the market does not believe, I think it could be a re-run of Ryanair 15 years ago

·         Fundamental upside in this case would comfortably be 60%, well above our hurdle rate of 30%

·         Management have delivered so far and are clearly incentivised to continue to do so given net worth tied up in the equity

Negatives:

·         Overlap with Ryanair probably in the range of 20%-30% - obviously a strong competitor

·         High degree of operating leverage in the business - 1% off the load factor is 6% off the earnings

·         Capitalising the leases also reveals that the financial leverage is quite high, so potentially a toxic mix if load factor heads south

·         Historically, airlines have been a tough business and not really a place for fundamental value guys (low barriers, low ROIC)

·         Events in Ukraine give a sense of the political risks involved in the CEE-centric business model

·         Generally negatively impacted by USD strength (see sensitivities below)

·         Doubled capacity in 5 years, looking to double again over next 5 then add another 50% over next 3 - a lot of capacity to fill

·         CFO recently left, citing personal reasons

Some other useful info:

·         Fuel hedge coverage 67% in $744-$754 range 2016; 61% in $672-$676 range in 2017

·         USD hedge coverage 67% in $1.15-$1.21 range 2016; 43% in $1.09-$1.13 range in 2017

·         Sensitivities (pre-hedging) - $10 on fuel is $1.5m on costs; $0.01 on EURUSD is EUR 1.4m on costs

·         45% of ancillaries related to baggage, 55% ex-baggage and growing much faster (about half growing at 9%)

·         Capacity growth will be used 60% building frequency on existing, 30% back filling, 10% new routes

·         Per share estimates are based on FD share count which differs markedly from the number appearing on Bloomberg

Catalyst

No catalyst