Ryan Air — The times they are a changin’
Investing, at its finest, has never been about the past, because a company’s intrinsic value is essentially the aggregate discounted future cashflow that the company can generate. 2020 has been a bad year for the airline industry, to say the least. All are loss-making. Airlines either have gone bankrupt are on a brink of one. Those that have managed to survive until now are burning through billions of dollars a month. However, despite bleeding cash, some stocks in the industry have climbed back up to their pre-pandemic levels , one of which is Ryan Air. Once a humble player whose strategy is to use aggressive cost-control to keep tickets price low, Ryan Air is vying to increase its market share by taking advantage of the paradigm shift in the post-Covid era of airlines. The two most significant shifts, in my opinions, are (1) business travel segments will significantly contract as we are given time to get used to teleconference tools and (2) leisure-travel will become the driver of growth for the industry in the coming years, for WFH could also mean working at a beach somewhere in Bali.
Apparently, Ryan Air’s CEO Michael O’Leary has the same idea and is planning to capitalize on the airline’s inherent strength in that growing leisure travel segment. Not only that, as its lesser-known rivals who have less access to the capital market tumble, the budget airliner, with an already shored-up balance sheet, looks ready to pick up some market share. Thus, one could make a strong investment case for Ryan Air, and I am writing this post to examine this idea more closely.
A closer look at its performance, Ryan Air stands out against its European and American peers (already excluded those with not meaningful ROIC and Net Leverage figures):
The table above demonstrated Ryan Air’s efficient use of capital and its low-levered balance sheet. Among its peers, it boasted an impressive ROIC and low net leverage ratio. Just a quick look at several key KPIs could give partly an understanding of why it is one of the hottest stocks in the airline industry while others either go bankrupt or get into administration.
To determine whether the stock can still extend its ebullient run, I am coming back to my favorite tool: Discounted Cash Flow model
Valuation Model and Results
For the DCF model, here are my main assumptions:
There is no doubt some of Ryan Air’s small competitors would face bankruptcy. Meanwhile, big players such as Lufthansa and Air-France would face massive restructuring in order to compete squarely in the low-margin high-volume. That is the opportunity for Ryan Air to pick up some of the market shares. Thus, it will be able to recover to its pandemic revenue level in 2024 and by the end of the decade will almost double that revenue to reach EUR 16bn by revenue. At steady-state, it is assumed to grow at 0.7 percent per anum, equal to 10-year UK gilt yields.
- Capital efficiency
Pretax operating margin (EBIT) will be floundering for the first few years, but will gradually converge to its pre-pandemic level of 13.5 percent. Sales/Capital is set at 1.5 as the airline experiences euphoria from the economic rebound but will gradually slow down to the industry average of 1.
- Cost of Capital
As a European firm, the company enjoys a low cost of capital:
For the inputs mentions above, my valuation model produces the following result:
Value of equity in common shares of EUR 21.2bn translates into EUR 18.8, 20% above its current price of EUR 15.7. In this particular valuation, I boldly assume there is no chance for Ryan Air’s bankruptcy. The presupposition is backed by two reasons: (1) governments, for better or worse, will extend its fiscal support for businesses affected by the pandemic and (2) Ryan Air will easily navigate its way through stormy economic crises due to its strong balance sheets, low-cost business models.
There are two most important and sensitive inputs of this model: EBIT margin at steady state and revenue growth rate for year 2–5. As a result, I conduct a sensitivity analysis to observe the dynamics of the final value per share as the two factors vary:
One can easily lay down a probable bear case for Ryan Air: tepid growth and low EBIT margin, weighed down by weak demand and fierce competition from rivals who will be fighting for their survivals. At 10% EBIT margin (way below its 13.3% pre-Covid level) and 8% growth (at year 10 it would reach EUR 10bn in revenue implying a 2019–2030 CAGR of 2 percent), it would earn a value of EUR 10 per share.
As a contrarian investing apprentice, I am tempted to rummage through financials to search for value and invest in an industry that is on life support such as the airline industry. With a strong balance sheet and a nimble cost structure that will serve as its main competitive edge against other competitors, Ryan Air earns a “buy” recommendation from me, even its stock has climbed back up to its pre-pandemic level. I do believe that the airline will claim its place as one of the biggest players in the field if it can ruthlessly exploit opportunities presented to them.
Timing-wise it is not a good time to buy-in. As investors are still euphoric of relentless monetary and fiscal support from central banks and governments from around the world, stock prices, including that of Ryan Air, stay elevated and do not justify their fundamentals. Additionally, there are grim indications of hard times still being ahead of us, amid slow roll-outs of coronavirus vaccines, new variants of the Covid-19 that render some of the vaccines ineffective, and, due to disrupted global supply chains, rising inflation that will sap away consumers’ purchasing powers. Also, its future heavily rely on the outcome of the airliner’s lawsuit against its two nemeses Air France and Lufthansa for their alleged practices of selling below cost. If, in fact, the two companies have the support from the governments and can thus capture market shares by selling tickets below cost, Ryan Air will find itself struggle competing against these two state-supported (???) airlines.
Can Ryan Air ever break into the league of the industry’ titans? Will they be able to AND be allowed to execute their strategy? Can 2021’s summer be saved? That only time will tell…
As usual, I am providing my valuation spreadsheet in the following link:
Ryan Air's valuation sheet and peer analysis data. Contribute to vthiep94/RyanAir development by creating an account on…
Catch you guys in the next post! (There will be one)