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EasyJet at 20 years of age

Published: 12:54 23 Nov 2015 GMT

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EasyJet recently announced its fifth year of record profits and is well placed to deliver another strong results in the current year.  However, the share price has fallen from £17.83 before the results to close at £16.83 last Friday.  While investors appear to be unimpressed the valuation remains attractive.

On November 10 1995 easyJet operated its inaugural flight from London Luton to Glasgow.  Sir Stelios Haji-Ioannou founded the company in March 1995 with the focus on providing cheap European flights.

Both easyJet and Ryanair took their inspiration from Southwest Airlines – “the original budget airline” – of the United States.  Southwest, established in 1967, and as of 2014 is the leading US domestic airline by passenger numbers.

EasyJet celebrates its 20th birthday

 

 

Source: EasyJet website

The aim of budget airlines (or low cost carriers) is to offer low fares versus the legacy flag carriers.  This has a broad appeal for the short-haul – less than three hours – flights that are the principle focus of budget airlines.  

Leisure travellers generally prefer to spend money on the holiday experience, such as staying in a nice hotel, than on an expensive flight.  This is less true for long-haul flights (over six hours) where comfort and service is important.

To offer low cost flights the budget airlines must keep costs low and maximise revenue.  Low-ticket prices help to boost overall revenue as it helps achieve high load factors i.e. full planes.

The pricing structure is such that the first tickets bought are very low cost and then become more expensive as an aircraft fills up.  This means that for late bookers the price of a budget airline ticket isn’t necessarily cheap.

European budget airline ticket prices versus flag carriers

 

 

Source: Ryanair investor presentation

Revenue maximisation strategies also include paid for add-ons such as allocated seating, on-board sales and ancillary services like car hire.  The sector has had a reputation for trying to catch consumers out with hidden charges. 

Turning to costs and budget airlines have a number of ways to keep these lower than the legacy carriers.  Nearly all budget airlines tend to have only one or two types of plane to increase reliability and reduce servicing costs.

Budget airlines also typically have modern and efficient planes, which improves reliability and reduces fuel costs.  The key for the sector is to have a rapid airport turnaround and few aircraft maintenance issues.

A further budget airline strategy is to focus on direct booking by phone or through the Internet.  This helps cut out the middleman and makes each passenger more profitable and potentially more loyal to a particular brand.

Airline costs excluding fuel

 

 

Source: Ryanair investor presentation

Budget airlines have tended to focus on cheaper “secondary” rather than the busy primary airports such as Heathrow.  However, this can increase the total transport cost to passengers to arrive at their intended destination. 

With budget airlines fairly new on the scene the extent of staff unionisation is low by industry standards.  This helps reduce the wage bill and allow for greater staff flexibility in shift patterns.

These cost advantages tend to be most pronounced on short-haul routes that the budget airlines focus on.  For long-haul trips the proportion of costs made up by fuel is high and passengers are likely to want adequate service levels.

 

Budget airlines in Europe: Ryanair & easyJet

According to Reuters the legacy carriers in Europe control 58% of the short-haul market.  EasyJet estimates that its market share in the segment is 8% and as such there should be plenty of room for growth.

Ryanair is the largest budget airline in Europe carrying 90.6m passengers in the year to March 2015 versus 66m carried by easyJet in the same period.  The CEO of Ryanair, Michael O’Leary, has boasted that he has competitors “on the run.”

With Ryanair looking to double the number of passengers carried by 2024 it is a clearly a threat.  Ryanair has also put in place a customer service improvement programme and is increasingly moving to primary airports. 

EasyJet’s CEO, Carolyn McCall, has dismissed the threat from Ryanair for the time being stating that the current overlap is only on 5-6% of routes.  The crux for easyJet’s investors is whether conditions will become more competitive.

In our view, it makes sense for the budget airlines to first go after the legacy carriers as these are easier and more profitable to take share from.  Direct competition between budget airlines is less attractive.

Budget airlines also have scope expand the European airline network because the low fares can make minor routes attractive.  Expansion can also be achieved through greater network connectivity on point-to-point routes.

By way of example if there were only two airports in Europe then there would only be one possible route.  However, with six airports there would be 10 separate point-to-point routes between all of the airports.

 

EasyJet’s market position

EasyJet has a strong network in the primary airports of Europe with a 58% market share at Gatwick.  At Belfast International the group has an 84% market share, at Berlin Schonefeld it is 58% and at Basel Mulhouse it is 54%.  

This helps generate airport economies of scale and creates a network with high volume routes for the company.  In Europe’s top 25 catchment areas by GDP the group has 12 number one or two positions in the primary airports.  

This makes easyJet well placed to take market share from legacy carriers and attract business travellers.  The group appears confident as in its full year results it upgraded the rate of “base case” growth for its aircraft fleet. 

This was due to: “high demand for easyJet flights and the number of profitable opportunities we see in our markets”.  Looking at a recently launched route – Gatwick to Preveza in Greece – and pricing for next summer is very strong.

EasyJet appears to be higher cost and has higher airfares than Ryanair but this mainly reflects its greater focus on primary airports.  These are more expensive to operate from but deliver greater value to passengers.

 

 

 

EasyJet final results and fuel hedging

With strong summer trading we saw easyJet’s earnings per share for the year to September jump by 21.5% to 139.1p.  Passenger numbers rose by 6% to 69m with the load factor up by 0.9% to 91.5%.

The group’s return on capital improved by 1.7% to 22.5% last year and the profit before tax margin rose by 1.8% to 14.6%.  EasyJet’s policy is to payout 40% of profits as dividends and the payout for last year is therefore 55.2p.

The group had net debt at 14% at the end of September 2015 versus 17% at the start of the year.  This should put the company in a strong position to meet the cost of its aircraft fleet expansion program.

In the current year a challenge will be weaker airline fares as the sector passes on fuel price savings.  EasyJet paid US$977 per metric tonne (pmt) in the year to September 2014 but this fell to US$872 pmt last year.

In the current year to September 2016 the group is 83% hedged at US$830 pmt and then in the following year it is 60% hedged at US$664 pmt.  As such it will take at least a year for the really significant fuel savings to come through.

 

Summary and valuation

Cyclical industries tend to overinvest in the good times and suffer prolonged downturns in the bad times.  The airline sector has suffered from over capacity in the past but also tends to see long-term growth.

Investors are currently concerned on European airline capacity given the expansion plans of the main operators.  The recent terrorist incidents have also likely to hit easyJet’s short-term trading results.

However, easyJet has survived worse turbulence in the past and has become increasingly diversified.  The threat of competition from Ryanair is real but maybe overstated as both companies continue to go after the legacy carriers.

Looking at easyJet’s P/E forecasts and for the year to September 2016 the P/E is 11.3X with a 3.6% yield (at a share price of 1685p).  The P/E falls to 9.9X in the following year and then 9X with the yield at 4.1% and 4.5% respectively.

This is a notable discount to Ryanair’s forecast P/E of 15.9X for the year to March 2016 and then 13.8X for the following year.  The valuation of easyJet appears to be attractive although near-term trading is also likely to be weak.

This report was produced by Fat Prophets Senior Analyst, Andrew Latto

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