|Shares Out. (in M):||1,490||P/E||12.8x||10.3x|
|Market Cap (in $M):||7,033||P/FCF||N/A||13.5x|
|Net Debt (in $M):||1,383||EBIT||740||900|
This write-up will be brief and high level as my annual posting requirement crept up on me. I am happy to answer questions in the messages section below.
Ryanair is Europe's leading low cost airline, with a business model based on many of the principles pioneered by Southwest in the US. Following full deregulation of EU skies in 1997, CEO Michael O'Leary has transformed Ryanair from an insignificant regional carrier into one of Europe's largest, with ~10% share of the short-haul market.
Airlines tend to be hazardous to one's wealth, but we feel that Ryanair is a breed apart. Its costs are the lowest in Europe by a stretch. After studying Ryanair's competitors, we feel that this is a durable competitive moat. Further, the company has never lost money at the operational level and has managed to grow book value per share at a compound annual rate of 17% over the last 10 years.
We believe Ryanair is the clearest structural winner in the European transport space, as its strong balance sheet and low costs have allowed it to take considerable share from overleveraged peers during the economic downturn. As its capacity growth slows over the next few years, higher cost competitors retreat, and the economy recovers, we believe yields can gradually move up to the €40+/passenger level that prevailed before the recession. Studying the history of Southwest is instructive, as its yields and returns really ramped following the early 1990s recession, when it was at a similar stage of maturity. A full restoration of pre-recession yields/margins would see EPS more than double and ROCE move back to ~15-20%. Even as fares recover, Ryanair should continue to gain market share as Europe's flag carriers freely admit that they can't compete with Ryanair's cost structure and are increasingly deploying resources towards premium and long-haul.
Ryanair has lots of cash and an extremely young fleet - both huge advantages vs. peers - allowing it a lot of flexibility in terms of future capex. Following failed negotiations with Boeing for aircraft deliveries post-2012, mgmt recently returned €500 mn of excess cash to shareholders (10% of current market cap) and has suggested that it could return another €500 mn in 2013. Assuming the company takes a capex "holiday" thereafter and allows its fleet to age to the industry average of ~10-12 years, we calculate a mid- to high-teens free cash flow yield (CFFO less maintenance capex) through the end of the decade using what we believe are reasonable assumptions (more info below). Even if mgmt does find an attractive aircraft deal by 2013 and decides to continue growing, we believe this exercise shows that the equity is substantially undervalued.
The stock has underperformed the MSCI Europe since March '09 as the airline industry, with its high fixed cost base and limited short-term flexibility, has been slower to recover than other cyclical industries. More recently, it has underperformed due to the spike in oil prices. We expect better performance going forward. We believe medium-term upside is in the ~€5.00-6.00/share range based on reasonable multiples of mid-cycle EBITDAR, earnings, and FCF.
CEO O'Leary owns ~3.7% of shares outstanding - worth ~200x his annual compensation - so is clearly aligned with shareholders. Chairman of the Board David Bonderman owns another ~1% of the company and has proven over his career that he knows how to maximize equity value. Mgmt has made early investors ~7x their money, outperforming the MSCI Europe by >10% a year.
Among the long list of risks associated with investing in airlines, we feel the biggest is that industry capacity returns too quickly such that yields cannot fully recover. Capacity can come from resurgent legacy carriers, but given the reality of differences in cost structures, we feel this is unlikely. Capacity can also come from low cost start-ups, but we believe they are less likely to emerge than in prior cycles because the European economy remains weak, consolidation has increased (e.g., the merger of British Airways and Iberia), and venture capital and other forms of financing are scarcer. Further, Ryanair's unit costs are considerably lower than after the last downturn, making it harder for start-ups to compete. Bottom line, we believe barriers to entry have risen vs. previous cycles and that Ryanair's competitive moat remains solid.
Margin of Safety
With the stock trading at a premium to liquidation value, our margin of safety is provided by the following: (1) an industry leading cost structure; (2) huge growth/market share potential; (3) a strong, cash-laden balance sheet; (4) high historic profitability (avg. margins are >2x the nearest competitor); and (5) a 10%+ free cash yield (excluding growth capex), even on depressed earnings. A quick note on asset value: Ryanair's signed a hugely favorable contract with Boeing during the post-9/11 industry downturn and has since sold planes in the secondary market at a premium to purchase price (some after 5+ years of use), either to other airline operators or to third-party leasing companies. Redburn recently estimated Ryanair's net fleet value at €3.34/share using data provided by Ascend Aviation, but one would probably need to apply a ~20-40% haircut in the event of a liquidation due to likely discount required to move 219 owned aircraft. Book value of ~€2/share is probably a better approximation. The stock has traded near this level just once in its history, during the Irish/global panic of late '08. Given Ryanair's growth potential and current equity price of ~6-8x normal earnings and FCF, we feel realistic downside is well above this level.
How We Differ from Consensus
This is not a name in which our near-term forecasts are wildly different than consensus, but we feel that the market under-appreciates a few important aspects of the Ryanair story. First, the market does not seem to appreciate that the severity of FY08-10 fare declines was driven in part by mgmt's decision to take advantage of crippled competitors in many markets. As a result, forward estimates do not seem to fully reflect the benefits of lower competition/peer capacity against slowly rebounding demand. Second, as noted above, the market does not seem to fully appreciate that Ryanair's competitive position and the durability of it has been strengthened by the downturn. Third, the market does not seem to fully appreciate the cash generating potential of this company as it moves into a period of lower growth. The company's current valuation suggests that it is stuck in a kind of temporary purgatory in which growth-oriented investors have abandoned it while more value-oriented investors are still in the process of discovery.
Free cash flow
We have a fairly elaborate cash flow model that is too messy to post here. It basically shows what happens to Ryanair's free cash flow in the event that it stops growing and allows its young fleet (average aircraft age is ~3 years) to age to the 10+ years of its competitors. Our forecasts show FCF of ~€850-1,000 mn annually (high teens FCF yield) from FY13-17 before gradually falling to ~€600 mn (still >10%) by the end of the decade. Note that the FCF yield excluding growth capex is already double digits, even on depressed earnings. Our basic assumptions are as follows:
1. Beyond FY13, we assume long-term revenue growth of 2%, in-line with the annual rate of EU passenger growth over the past decade and the likely future growth rate of EU-area real GDP. This seems conservative as it does not assume a nominal/inflation (i.e., yield) component.
2. We assume EBIT margins peak at ~18% in FY13 - the final year of our P&L forecasts - and then fall 50 bps annually as the fleet ages and the company matures. This seems conservative in light of Ryanair's average EBIT margin of 24% in FY00-08, though we balance this against the fact that Southwest, a more mature LCC, currently does margins of 8-10%. As growth slows and the fleet ages, unit costs (ex. fuel) tend to rise faster than revenues - mainly on the labor and maintenance lines.
3. For simplicity/accuracy, we assume Ryanair earns no return on its incremental cash balance, as we believe mgmt is unlikely to let net cash grow as shown here.
4. We assume a small positive contribution from net working capital as growth in cash from forward bookings (unearned revenues + taxes) and other accrued expenses has historically exceeded growth in current assets. Our assumptions as a percentage of total revenue growth are below historic levels.
5. We assume baseline maintenance capex is currently ~€60 mn (~€50-75 mn per Ryanair's CFO) and will slowly rise towards ~€250 mn as the fleet ages. This is due in part to the fact that once an aircraft reaches a certain number of operating hours - usually around the 10-12 year mark - the aircraft requires a major overhaul. Note that there are zero aircraft purchases/disposals in FY14, so the ~€100 mn of gross capex in company guidance is essentially mgmt's view of maintenance capex in that year.
6. We assume the company will begin to replace some of its older planes beginning in FY15, starting with 5/year and working up to 15/year by FY20. The latter figure is based on our assumption that as the fleet approaches the ~10-12 year industry average, fleet replacement will average ~5% per year. We assume new aircraft will cost ~€35 mn (well above Ryanair's historic cost in the mid-20s), that disposed aircraft can be sold for ~€12.5 mn (average age of ~10-15 years), and that both purchases and disposals are done at an 80/20 split between owned and leased. For reference, mgmt assumes a useful life of 23 years in its depreciation schedule, with a residual value of 15% of cost.
7. Net capex of ~€520 mn in FY20, the final year of our forecasts, equals ~1.25x depreciation. This is around the average level for a mature airline, so the free cash of ~€600 mn in that year should represent more or less a steady, ex. growth state in the years beyond our forecast period. In the meantime, the youth of the fleet should allow ex. growth free cash to be well above this level for most of the decade.
Based on expected cash build, mgmt has suggested that it might return another €500 mn to shareholders in FY13 (~10% of the current mkt cap). Our forecasts beyond FY13 show that unless Ryanair gets a favorable deal on new aircraft and elects to grow again, cash will continue to build at a mid-teens rate annually, making further returns likely. Our forecasts show pre-return net cash exceeding Ryanair's current market cap sometime in FY18. FCF/share in the latter years of our forecast period would be meaningfully higher if cash is used to repurchase equity.
Note on the ADRs
EU regulations require that European airlines be majority owned and effectively controlled by EU nationals. In response to this, Ryanair's board has since 2001 essentially blocked non-EU nationals from owning the ordinary shares, listed in Dublin and London. Thus, the ADR - which represents ~40% of total share capital and is nonconvertible - is the only way for foreign institutions without an EU address/registration to express ownership in the equity. Since this rule came into place, the ADR has traded at a premium to the ordinary shares, ranging from +7% to +65% over the last 5 years, with a typical range between 10% and 25%. The current premium is ~18%, towards the middle of the long-term range. Given the large upside we see in the ordinary shares and the fact that the ADR premium has only dropped below 10% on a few brief occasions in the last 5 years, we view this situation as acceptable. No change in EU restrictions appears to be on the horizon, and according to Ryanair management and several industry analysts to whom we have spoken, any change would be well-telegraphed and take a few years to come into effect. It is something we will continue to monitor. Until then, the ADR premium seems highly likely to persist.