easyJet fleet decisions: providing shareholder value? August 2013
This year's Paris Le Bourget air show as usual exhibited the normal flurry of announcements for aircraft orders. In total the manufacturers were able to announce firm orders for 696 aircraft with letters of intent for a further 383 orders along with options for a further 447.
Notwithstanding all the caveats about the validity of orders announced at air shows, in total the industry appears to have ordered a total of 2,191 aircraft so far this year; not far short of the 2,551 net orders achieved in 2012. The industry backlog now stands at nearly 11,900 units up by more than 1,250 from the end of 2012, and is equivalent to more than eight years of current production. This may add fuel to the idea that there is an order “bubble”.
The two largest single orders at the show were from Ryanair and easyJet; the one for 175 737s, the other for 135 A320s. Both of these dominant European LCCs had each entered long term aircraft acquisition agreements respectively with Boeing and Airbus for very advantageous prices in the early noughties. Both deals were coming to an end and both carriers, while recently reducing the rate of capacity expansion, had been actively looking for new deals to provide for replacement and growth over the next decade.
There the similarity may end. Comment on Ryanair's orders will have to wait for another issue; in this article we concentrate on easyJet's position.
easyJet uniquely has Stelios Haji-Ioannou as a major shareholder who has publicly slated the company he founded for even considering the idea of buying new aircraft. The main focus of his arguments seem to be that it would be better for the airline to stop growing and allow margins to expand to over 10%, than to spend billions at list prices (forgetting the significant discounts) and destroy shareholder value (which is what the industry as a whole is perceived to do). His arguments may seem preposterous from the founder of and airline in an industry wedded to the idea of growth, but may have validity if the acquisition of further capacity could be seen to generate marginal revenue below marginal cost.
easyJet's original aircraft deal in 2002 with Airbus provided for up to 315 aircraft. The original contract was for 120 firm orders and 120 purchase rights at prices reputed to be at more than 50% discount to list prices. This was extended in 2006 to add a further 75 purchase rights. By May this year 230 aircraft had been delivered with a further 15 deliveries due by 2014; while there are a further 70 options and purchase rights that could be exercised.
The new Airbus order
The new arrangement with Airbus signed this year (approved by shareholders despite Stelios's objections) allows for an interim “bridge” contract between 2015 and 2017 and a “new generation” contract from 2017 (when the A320neo should be available) to 2022. Under the “bridge” contract easyJet has ordered 35 A320 aircraft (with CFM engines) and has options and purchase rights for a further 35 (while retaining existing 35 options and purchase rights) – and may be seen as a pure extension to the 2002 arrangement.
From 2017 the “new generation” contract encompasses firm orders for 100 A320neo up to 2022 and an additional 100 purchase rights (to be exercised by 2025). The company states it has agreed ceiling prices (which may come down) with both CFM for the LEAP, and Pratt & Whitney for the PurePower engines – and is obviously leaving the engine manufacturers to pitch against each other for the contract.
With such hostility to growth plans from Haji-Ioannou, the company has gone out of its way to explain why and how it made the decision to go with Airbus. One of the more telling comments has been that it is getting the same level of discounts on the A320s in the period up to 2017, but even greater discounts to list prices for the A320neo after that (perhaps just making it the same effective acquisition price).
In one sense easyJet has had a cost disadvantage against Ryanair in the number of seats per aircraft. Ryanair had standardised on 180 seat 737-800s, but easyJet had a mixture of 156 seat A319s and 180 seat A320s. As fuel prices jumped it became apparent to easyJet that the unit cost advantage of higher capacity aircraft outweighed the flexibility on thinner routes provided by the A319: the A320 with 15% more seats is 7-8% per seat cheaper to operate than the A319. The move to the A320neo, the company states, will add a further 4-5% saving in costs per seat – mostly provided by the fuel advantage of the new generation engines offset a little by a modest increase in ownership costs.
The company has reiterated the flexibility it has built in to its fleet plans. Its base case is for the fleet to grow to 276 units by September 2022 (from 217 this year) – but has the possibility to allow the fleet to grow to nearer 300 (excluding the additional purchase rights) or slim to 165 units by the same year (on the scenario of cataclysmic disaster in 2014).
In the attempt to allay Stelios's objections the company has highlighted that the deal with Airbus fits in with all its financial targets.
Is Stelios right?
We have analysed the public data from easyJet since 1999 to try to see if the idea that the company itself is starting to mature to a point where growth could be destructive to shareholder value – seemingly Stelios's main thesis. We have looked at a series of measures presented in the charts on the previous page: the marginal revenue growth and marginal cost increase by average number of annual aircraft; the marginal revenue growth and marginal cost increase on the basis of the total number of seats on those aircraft – to take account of the varying fleet gauge. We have not considered actual traffic, and as we are looking at the total effect of the number of aircraft we have not included actual flown operations. We have additionally done the same calculations excluding fuel costs from both revenues and costs.
The results of this analysis as shown in the charts on the previous page seem to show little to suggest that easyJet's addition of aircraft to its fleet has not normally been accretive to shareholder value.
Despite the vociferous complaints from Stelios, the stock markets believe the easyJet story. Its share price, despite recent weakness, has more than doubled in the past year. The company has been elevated into the FTSE100 and is now the largest airline in the UK by market capitalisation. It boasts one of the highest returns on capital (along with Ryanair) in the European industry. And unlike most airlines worldwide it pays a dividend.
|Flexibility and increasing the proportion of A320s in the fleet|
|Fleet plan – base case||226||231||241||256||261||264||269||276||276|
|Average age of fleet||5.8||6.4||7.2||7.6||7.7||7.8||8.3||8.0||7.9|
|Seats flown growth||4.7%||4.6%||5.4%||4.8%||3.0%||3.0%||3.0%||2.8%||3.1%|
|Return Targets||Earn returns in excess of cost of capital through the cycle||Improve profit before tax per seat to £5|
|Invest in growth opportunities where returns are attractive||ROCE including operating leases|
|Capital structure and liquidity||Ensure robust capital structure||Maximum gearing of 50%|
|Return excess capital to Shareholders||Target £4m cash per aircraft|
|Maintain sufficient level of liquidity to manage through the cycle and industry shocks||Cap of £10m adjusted net debt per aircraft|
|Dividend policy||Target consistent and continuous payouts||3 times cover, subject to meeting gearing and liquidity targets|
|Annual payments based on full year profit after tax|
|Consider returns over 3 times cover to reduce excess capital|
|Aircraft ownership||Maintain flexibility around fleetdeployment and size||Target of c.70% owned aircraft,c.30% leased aircraft|