Ryanair: Steamrollering to €1bn net profits June 2015

Unless there is some external negative event it is probable that Ryanair will produce a net profit of over €1bn in FY2016 (official, cautious guidance is €940-970m) on revenues of €6.1bn.

The bottom line, literally, in Ryanair’s Investor Presentations is “Forecasts subject to ‘LF active/price passive’ policy”, which is at first sight fairly innocuous — the European LCCs have all subscribed to the notion that the important thing if to fill the aircraft to 80-90% with the average fare being the means to do so. But Ryanair is carrying this further: O’Leary contrasts this, Ryanair’s core strategy, with the other LCCs’ (mostly easyJet’s) aim of maximising RoCE and making promises on RoI.

What does this mean in practice? Especially, as the share price chart (on the next page) shows, Ryanair is, according to the stockmarkets, the leader in providing investment returns over the past three years? And Ryanair’s RoCE is around 20%, roughly the same as easyJet's; IAG and the Lufthansa Group are achieving 12% and 8.5% respectively; Air France/KLM is negative.

To illustrate what we think it means, and explain the distinction Ryanair is making: the chart on the right compares Ryanair’s more-or-less fixed fleet plan — adding over 200 737-800s over the next seven years — with easyJet’s flexible plan — maximum growth of just under 100 A320-types over roughly the same period, which is close to easyJet’s Base Case plan (how it expects it will develop). But at minimum, if things go awry, it could reduce its fleet by 30 units to 200, still staying within the contracts agreed with Airbus.

So, easyJet will respond to a recession or downturn in trading conditions by slowing or reversing capacity growth, in the expectation of pushing up unit revenues or at least stabilising them. But Ryanair will continue to add capacity in a downturn, confident that its much lower cost structure will mean that it can schedule services profitably when its competition cannot, inevitably capturing more traffic from its rivals, stressing them financially, maybe forcing them out of business. For this strategy to work, Ryanair doesn’t have to worry about unit revenues too much — “Load factor active/price passive”. And, as O’Leary has pointed out, Ryanair does not have explicit RoCE targets for the investment community to become fixated on.

This is a classic economics game — place your bets.

Cost differentials

How sustainable is Ryanair’s cost advantage? In its latest investor presentation Ryanair puts its average seat cost at €29, 45% below easyJet, 53% below norwegian and 73% below airberlin.

The price differential with easyJet has not changed over the past year despite the implementation of “Always Getting Better”. Perhaps this is not surprising as the elements of AGB — allocated seating, removal of extreme penalties, free extra bag, revamped website, etc — are mostly concerned with removing Ryanair’s unnecessary aggressiveness rather than any fundamental strategic change — as O’Leary mused, “If I had known I could make more money by being nicer, I would have done it much earlier.” (There are still quite a few unpersuaded customers out there, however.)

The main low cost dynamics still appear to be in place:

• Fleet: Ryanair’s current delivery schedule comes from a 180-unit order of 737-800NGs, which are end of production line aircraft whose unit price was further depressed by Airbus’s success with the early A320neo orders at the time, mid 2013, when Ryanair finally committed its order. Then, from 2019 Ryanair will start to take delivery from its order (100 firm plus 100 options) for the 737 MAX, with seating of 197 seats (against 189 for the current fleet) and a claimed, guaranteed probably, improvement in fuel efficiency of 18%.
• Airport charges: This represents the big difference between Ryanair and easyJet — €8 against €21 per seat — a gap which must diminish as Ryanair expands into more and more mainstream airports (the only ones excluded from its possibilities are Heathrow, Frankfurt Main and Paris CDG). Yet Ryanair still does innovative deals: at London Stansted, its second base, it drastically cut back capacity when the then owners, BAA, applied the regulatory maximum charges, and as a result total traffic at the airport collapsed by 25% between 2008 and 2011. With MAG (Manchester Airport Group) in charge following the mandated disposal of Stansted, all that traffic has been recovered and more, as Ryanair has expanded again, having signed a ten-year contract with MAG. We do not know what the price per passenger is for the additional traffic generated by Ryanair, but suspect well under £5/pax against about £6.5/pax according to the rack rate. All German airports, according to O’Leary, are interested in negotiating growth-related deals with Ryanair.
• Ryanair like easyJet (but unlike norwegian) has not benefitted from the fall in oil prices because it hedged at above the 2014/15 average price, and is 90% hedged at $92/bbl for the year to end March 2016. If fuel stays low Ryanair will benefit as the hedges unwind; if fuel prices soar it is protected.

Glossier easyJet

easyJet, by comparison, tends to concentrate more on its revenue side in its (much glossier) investor presentations, focusing on yield management and capacity disciple, both of which pushed up unit revenues by about £1.1 between the first half FY2014 and the same period in FY2015. However, adverse FX movement meant that the overall unit revenue scarcely changed — £54.9 against £54.8. Unit costs over the same period fell by £1.8 from £56.5 to £54.7/seat, but as the investor presentation makes clear, “management initiatives” as a whole accounted for almost none of the change, the decline coming mainly from a combination of fuel and FX effects. easyJet’s financial year runs to September 30, for which net profits of about £420m on turnover of £4.8bn are anticipated).

easyjet’s core strategy is its network. Within Europe it is the leading carrier in terms of number of market pairs operated between the 100 primary airports — 47 market pairs compared to BA’s 38 and Ryanair’s 22. It business orientation is illustrated by its route frequencies — 7 per week on average against 4 for Ryanair. It is the number one carrier at Gatwick, Edinburgh, Milan Malpensa and Geneva.

Ryanair responds by quantifying what happens when it enters a market. For example, it started Stansted-Edinburgh in January this year and by March was carrying 25,200 passengers, while easyJet’s long-established operation saw volumes fall from 25,500 in October 2014 to 22,800 by March. On Stansted-Glasgow, Ryanair also started in January and had built up to 24,200 pax by March; meanwhile easyJet’s traffic slumped from 24,000 in October to 13,700 in March.

So, according to Michael O’Leary, Ryanair will continue to become more and more dominant in the European market, because the cost gap between his airline and his rivals is so wide. They can claim that they do not compete directly with Ryanair because they have developed separate markets and/or products — primary cities (easyJet), eastern Europe (Wizz), loyal home base (Vueling), long-haul (Norwegian) — but ultimately, O’Leary warns, they will have to face their nemesis.

De-fragmentation

The European short/medium haul industry is fragmented, consisting of:

• The five main LCCs, each with a different strategy
• The short haul networks of the three global carriers, (of which only one, IAG, is currently successful, while the other two, Lufthansa Group and Air France/KLM are struggling (see Aviation Strategy, May 2015)
• Lower cost subsidiaries of the Globals — eurowings, Transavia, HOP!
• The remaining independent or quasi-independent national carriers — SAS, LOT, TAP, SN Brussels, etc.
• A subset: Etihad-invested airlines — air berlin, Alitalia, Air Serbia, etc
• The residual charter industry (UK charter passengers volume, for instance, has fallen by more than 50% over the past ten years — see Aviation Strategy, March 2015)
• The niche carriers — Aegean (successful hybrid but exposed to Greek crisis), Flybe (low-cost regional, floundering) and Volotea (ultra-niches and ultra low-profile)

Although the different airline models can to a large extent co-exist, some shake-outs are inevitable. In the medium term this could happen:

• Intra LCC mergers: Wizz has achieved unit costs similar to Ryanair, has the leading position in east and central Europe, and might possibly be a target for either easyJet or Ryanair. Ryanair has had much greater management continuity than easyJet, and O’Leary has the painful memory of the Buzz acquisition 15 years ago, while easyJet executives may know about the benefits of buying Go but may be unaware of the full costs and disruptions of that take-over. In any case Wizz now has a price — £0.8bn — its market capitalisation following its recent listing on the London Stock Exchange. Five years ago O’Leary dismissed speculation on Ryanair’s interest in Wizz by saying he valued the airline at five or six euros in total.
• LCC/National carrier mergers. The obvious combination would be Norwegian/SAS, a possible solution to the former’s struggling long-haul growth plan and SAS’s cost structure.
• Legacy spin-offs. According to O’Leary, the rationale behind the wrapping-up of its loss-making, non-hub European traffic in Eurowings is to distance the brand from Lufthansa, acknowledging that it will sooner or later be sold off or closed down. AF may be forced to do something similar with Transavia/HOP!
• Legacy/LCC link-ups. No-one has yet worked out how to mesh LCC point to point operations with the requirements of a global hub system, though Vueling has innovated. Vueling and easyJet would appear to be the obvious candidates for this short-haul outsourcing, with their experience in business-orientated traffic. Yet Ryanair could surprise, by coming up with the lowest cost solution.