Warren Buffett

Warren Buffett‘s well-known for being wary of airlines. A good example is the following from the 2013 Berkshire Hathaway shareholder meeting: “You’ve got huge fixed costs, you’ve got strong labour unions, and you’ve got commodity pricing. That’s not a great recipe for success.”

The issue is that most of the costs associated with a flight – the plane, staff, fuel – are all fixed. They don’t change much depending on how full it is. That gives operators a strong incentive to fill the aircraft at pretty much any price. And the main thing customers care about is how much they’re paying.

As a result, airlines generally can’t charge any more than their nearest competitor. But that competitor might be charging nearly nothing to fill a plane.  Given this, it might be unclear why anyone should be interested in the industry at all. Buffett however, has bought US airlines stocks more than once.

Competition

The problem for airlines is that there’s too much competition. This leads to low prices for customers and low returns for businesses. It doesn’t really matter whether a rival makes any money on a low-cost flight. If they’re selling it, people won’t buy a more expensive one.

The US has already seen some consolidation and is now dominated by four main carriers. These are the four Buffett bought in 2016.

Ryanair (NASDAQ:RYAA.Y) CEO Michael O’Leary sees this coming in Europe. He’s identified both easyJet and Wizz Air as potential takeover targets.

I’m unsure about this. But I do see the latest difficulties as a chance to have a look at what I think is the outstanding name in the industry.

Which stock?

There’s only one way to stand out in an industry where customers are driven by price. And that’s to have lower costs than everyone else.

The firm that does this best is Ryanair. It is relentlessly focused on keeping its own costs down so it can charge customers less than competitors.

It flies from less busy airports, keeps turnaround times short, and uses one type of aircraft. But the real highlight is the way it manages its fleet. Ryanair’s outstanding at finding opportunities to buy aircraft at a discount. This is often when Boeing is in some sort of difficulty and needs orders.

That puts the business in a position to make more money than competitors while charging customers less. And I think that’s a winning formula.

Time to buy?

The airline industry is one that I’m generally not interested in. But Ryanair is a rare – in fact, unique – exception. The company isn’t immune from the effects of higher oil prices. Fuel is one of its biggest costs, so it’s likely to have a real impact.

My view is that it’s likely to be much more resilient than rivals. This comes from its uniquely low cost base and best-in-class balance sheet. That’s why I think the falling prices across the industry might be an opportunity for me that I’ll investigate further. But only in one particular stock.

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Even with the industry as a whole set for yet another downturn, I think there’s an opportunity here. The near future looks challenging, but I’m much more positive about the long-term outlook.

Weak demand

Air travel is a cyclical industry. When household budgets come under pressure, consumers often find themselves looking to be more cautious with their spending. 

This, according to Ryanair, is what’s happening at the moment. And the effect is the company’s profits for the second quarter of 2024 fell by 46% compared to the previous year.

In response, the business is looking to reduce its fares for the summer. That’s likely to mean lower profit margins, but there’s a positive that investors should take note of.

Weak travel demand isn’t a good thing for Ryanair, but it’s much worse for other airlines. As a result, I think the company might well emerge from this year in a stronger competitive position.

Low costs

Ryanair has two major advantages that equip it better than other airlines to deal with cyclical downturns. The first is that it has lower costs than its rivals. 

Ryanair vs. easyJet vs. International Consolidated Airlines Group Operating Margin 2014-24

Created at TradingView

Despite having the lowest fares, Ryanair maintains wider operating margins than easyJet or International Consolidated Airline Group. This is because it has the lowest costs in the industry.

Avoiding expensive airports, owning aircraft instead of leasing them, and minimising downtime all support this. And it puts the company in a stronger position than its rivals when demand is weak.

Ryanair cutting prices should force other airlines to do the same. But without the same operating margins, they could find themselves forced into losses, rather than just weaker profitability.

Balance sheet

This situation is exacerbated by looking at Ryanair’s financial position relative to its rivals. Unlike other airlines, Ryanair’s balance sheet has recovered well from the Covid-19 pandemic.

Ryanair vs. easyJet vs. International Consolidated Airlines Group Total Debt 2014-24

Created at TradingView

Both easyJet and IAG are still spending a lot on interest payments on debt acquired during 2019 and 2020. With Ryanair, the company’s interest expense is roughly in line with its long-term average. 

Not having to worry about interest payments to the same extent also gives the company more scope to lower prices. And there’s another advantage too.

Airlines typically cut back on new aircraft in tough times. But Ryanair’s ability to buy when others can’t allows it to negotiate better prices with Boeing, creating another long-term advantage.

Airline investing

The main risks with Ryanair are events like Covid-19, Icelandic ash clouds, and cyclical downturns. The company can’t do much about these and they can cause profits to fall sharply.

Nonetheless, Ryanair’s business model has allowed it to emerge from each crisis in a stronger position than before. That’s why the stock has climbed 52% over the last five years and also why I’m looking to buy it at today’s prices.

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However, fast forward to 2022, and much of the lost flying time has been recouped. As people are free to travel again, I would expect airline stocks to be slowly climbing. Yet this hasn’t been the case. easyJet (LSE: EZJ), IAG (LSE: IAG), and Ryanair (NASDAQ: RYAA.Y) are down 40%, 33%, and 32% year to date respectively. Over a one-year span, the same stocks are down 49%, 35%, and 33%. So that being said, is now the time to buy back in?

Ready for take-off?

A big positive for airline stocks is the continuing increase in footfall. In 2019, just under 5bn people boarded flights. In 2020, this number fell all the way down to 1.8bn. However, in 2022, it’s forecast that just under 3.5bn customers will board flights, highlighting the impressive recovery. As this figure increases, it will help boost firms’ top lines, which I expect to be reflected in share prices.

Looking at company-specific results, I also see good news. IAG reported a profit for the three months to June 30 for the first time in two years. Ryanair posted a profit of £170m in its Q1 FY23 results too. Although easyJet recorded a loss of £110m for the same period, its revenues soared to £1.7bn, up from just £213m a year prior. In addition to this, its net debts shrank to just £200m, down from £600m in March 2022. These figures suggest to me the airline industry is in a more comfortable spot.

Not out of the woods yet

But there remain risks. A big threat that could continue to plague airlines is rising fuel costs. The Russia-Ukraine crisis sent the price of oil skyrocketing to over $120 per barrel. Currently sitting around the $100 mark, the price of jet fuel will inevitably have skyrocketed too, increasing operating costs and eating away at margins.

Another risk that airlines must overcome is rising inflation and how this is impacting workers’ wages. We’ve already been seeing union action regarding the erosion of pay in other travel industries. easyJet, Ryanair, and British Airways have all seen strikes this summer, and there’s no guarantee that these won’t continue.

Rising interest rates are also creating a harsh environment for stocks to thrive. I expect this bearish sentiment to be another reason why airline stocks have fallen.

Flying under the radar

Yet I think that airline stocks are back on the up. Shares have fallen due to rising fuel costs, the threat of industrial action, and the wider macroeconomy. However, with flight numbers rising, and industry leaders returning to profitability, I think now could be time to buy back in. As such, I’m looking at buying some UK airline stocks for my portfolio today.

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This surge in profits was driven by falling fuel costs and rising passenger numbers, which combined to lift Ryanair’s profit margin from 13% to 18%.

Investors were also impressed because seat utilisation rose by 5%, from 83% to 88%. The airline is targeting 90% this year, which could drive further improvement in profit margins.

Is Ryanair the best?

Ryanair founder Michael O’Leary’s promise to be nicer to his customers appears to be paying off.

The firm’s shares have risen by 61% over the last year. In today’s results, the airline’s management said it expects after-tax profit to rise by another 10% this year, to between €940m and €970m.

However, Ryanair isn’t the only carrier enjoying good times. British Airways owner International Consolidated Airlines Group (LSE: IAG) is also doing well. Profits at IAG, which also owns Spanish airline Iberia, recovered strongly last year and are expected to rise by around 55% in 2015 to €1,521m.

IAG is also thought to want to buy Aer Lingus, in which Ryanair has a 29.8% stake. Should Ryanair be forced to sell, enabling IAG to do a deal, then competitive pressure on Ryanair could rise on key routes.

Which airline is the better buy?

Both Ryanair and IAG offer potential for investors, but which airline looks the better buy today?

Based on these numbers, IAG looks a more appealing buy, but there are some other differences. Ryanair’s low cost structure means that its operating margin of 18% is more than three times IAG’s 5% margin.

All else being equal, this could mean Ryanair can generate more free cash flow than IAG and potentially offer greater shareholder returns, through dividends and share buybacks.

What’s more, both firms are targeting significant additional growth, but this sector is fiercely competitive. What’s more, Ryanair shares have risen by 180% over the last three years, while IAG has climbed 280% during the same period.

Is there another alternative with more untapped upside potential?

Enter Flybe

Flybe Group (LSE: FLYB) won’t be suitable for everyone. This loss-making £124m airline has issued a series of profit warnings which have seen its share price tank from a high of 150p in 2014 to just 56p today.

The airline has struggled to get rid of 14 surplus aircraft it cannot use that are costing a frightening £26m per year. However, solutions have now been found for seven of these aircraft and the firm raised £155m in a placing last year, so is well funded in the meantime.

Most of Flybe’s routes are short haul routes using small aircraft, where there is no alternative air service. This means that this company doesn’t necessarily face the same intense competition as carriers like Ryanair, IAG and easyJet.

When Flybe manages to resolve its legacy issues, underlying profits could to rise to around £19m, according to analysts’ forecasts for 2015/16. That breaks out as around 6.2p per share and equates to a forecast P/E of just 9.0.

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This trend is already driving passenger volumes across the industry’s major operators steadily higher, and budget airline Ryanair (LSE: RYA) announced just today that traveller numbers swelled 28% during March to 6.67 million. The Irish firm’s latest blockbusting results follows growth of 29% in February, as well as the 28% advance recorded in the previous month.

Ryanair commented that fare reductions and improvements to its forward booking system, combined with the introduction of its Always Getting Better customer service proposition — designed to shrug off its shoddy image by cutting fees, improving its website and revamping its aeroplanes — have specifically paid off in recent times.

Budget firms’ purple patch set to continue

But Ryanair’s show-stopping performance is far from a one-off, and a number of its low-cost operators have also punched sterling results in recent times as holidaymakers try to stretch their budgets that little bit further. On top of this, Europe’s cheaper carriers are also reporting surging demand from commercial travellers as businesses attempt to slash costs.

Exeter’s Flybe (LSE: FLYB) announced yesterday that passenger numbers were up 15% during January-March, a result which helped push revenues 5% higher from the corresponding 2014 quarter. And Wizz Air (LSE: WIZZ) — which only floated in early March — announced recently that it had “traded well through the fourth quarter.”

Accordingly transatlantic behemoth International Consolidated Airlines (LSE: IAG), operator of blue-ribbon airlines British Airways and Iberia, plans to increase its exposure to the budget arena by acquiring Dublin-based Aer Lingus.

International Consolidated Airlines has been in hot pursuit of the company for some time now, and with good reason — it announced just today that total passenger volumes across all its brands leapt 10.5% in March, to 6.3 million. The business acquired Spanish low-cost brand Vueling back in 2013, and the strong performance of its new acquisition is prompting the Heathrow firm to ratchet up its exposure to the budget sector.

With traveller numbers expected to keep on climbing, and expectations of persistently-low oil prices boosting the profits outlook for each of the firms I have mentioned, I reckon that these airlines are in great shape to enjoy splendid long-term earnings growth.

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Customer numbers in the quarter went up 13.6%, from 18.3m to 20.8m, and third quarter revenue rose 17%, to €1,132m, with unit costs (ex-fuel) falling 6%.

The airline’s Load Factor — a measure of  how efficiently it fills seats — increased by 6 percentage points, rising from 82% to 88%, which the company attributes to a combination of its “Always Getting Better” customer programme and its significantly expanded winter schedule. 

The company also announced a programme to buy back up to €400m ordinary shares. The shares will be repurchased starting 12 February 2015 and ending not later than 14 August 2015.

Commenting on the Q3 results Michael O’Leary, CEO of Ryanair, said:

 “As 2015 will be Ryanair’s 30th year of bringing low fares to Europe, we are pleased to report a Q3 profit of €49m.  These strong results confirm that our “Always Getting Better” customer programme and our expanded business schedules, coupled with our substantial fare and cost advantage over competitor airlines is drawing millions of new customers to Ryanair. “

At €9.76 Ryanair’s share price is up  a substantial 55% since this time last year, compared with a mere 4% gain by the FTSE 100. And over the longer term Ryanir is trouncing the index, with a gain of 192% over the past five years, during which time the FTSE 100 has only increased by 31%.

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Passengers are also turning to the low-budget UK airlines and others to escape the “winter blues” in January. I have picked three airline stocks worth investing in or re-visiting, whilst Brent crude continues its’ descent below $50 a barrel and office workers continue to spend their above inflation pay-rise on a dream holiday destination.

easyJet (LSE: EZJ)

This low-budget airline founded by Sir Stelios Haji-Ioannou in 1995, reported an upsurge in passenger numbers before Christmas. The load factor – a measure of how full its aircraft were – increased by 0.5 percentage points to 89.5%, with passenger numbers by 3.1% to 4,386,296 in November against the same month in 2013. In November, the Luton-based carrier also reported a rise in annual pre-tax profits by 21.5% to £581m, with a 6.3% rise in revenue to just above £4.5bn. Due to this positive set of results, broker Liberum lifted its target price from 1,650p to 1,725p and repeated its “Buy” recommendation. Liberum analyst Gerald Khoo said although the stock’s valuation is currently at a premium to its five-year average, this is “justified” by the “rapid and dramatic improvement” in the airline’s margins and return on invested capital in recent years.

Ryanair (LSE: RYA) 

Another low-budget airline doing well on the back of the falling oil price is easyJet’s rival, Ryanair. Ryanair’s shares hit a record high in early January, boosted by a rise in passenger numbers to 6.02 million in December. This rise translates to an 88% rise in seat occupancy for the month. The low-budget airline’s profit warnings of 2013 seem a distant memory for investors. It has also scrapped quite a few unpopular policies that weren’t currying favour with potential customers — for instance, Ryanair now allow passengers more carry-on baggage and have cut punitive charges. It has also improved its website and launched a service aimed at business customers. In December, Ryanair raised its forecast for pre-tax profits this year to between £636m-£655m), up from an earlier estimate of £584m-£600m.

International Consolidated Airlines (LSE: IAG)

The owner of British Airways and the Spanish carrier Iberia, ICAG group is currently in pursuit of Aer Lingus. After suffering several rebuffs, it raised its cash offer from an earlier €2.30 to €2.40 per share. If the takeover bid was successful, ICAG would gain more take-off and landing slots at Heathrow, and increase its passengers numbers on one of the world’s busiest routes (London to Dublin). Analysts have talked of the merits of the Aer Lingus merger for ICAG group including strengthening its transatlantic market position. Broker Liberum has reiterated its “Buy” stance, with 16 other brokers viewing the stock as a “Strong Buy”.

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With pricing competition fierce and margins wafer-thin, even a change of few dollars in the cost of a barrel can make a significant difference to the bottom line — and since last summer it’s fallen more than 50%.

Big international airlines

In response, International Consolidated Airlines (LSE: IAG) shares have climbed by 51% since early October to 489p today, reversing 2014’s decline to provide a 12% gain over the past 12 months. But is there any further to go and are the shares worth considering today?

Well, the company’s turnaround is expected to come good this year, and third-quarter operating profit was up 30% to €900m. Fuel costs were down 7.5%, and that was before the great oil slump!

Forecasts put International on a P/E of only 7.9 for 2015, dropping to 6.5 for 2016 when dividend yields are expected to be back to 2.6%. I generally don’t like airlines as an investment, but this one is looking tempting.

And budget ones

Shares in easyJet (LSE: EZJ)(NASDAQOTH: EJTTF.US) have been on a similar turnaround, falling until mid-August before recovering a little, and then they’ve shown a mirror-image of the oil price to gain 28% since late September. We’ve just had an update for December, too, and passenger numbers are up 3.2% over December 2013 with rolling 12-month passengers up 6.5%.

As a budget airline, easyJet has done well to keep its earnings growing, but the shares are on a forward P/E of 13.3 for September 2015 and dropping only as far as 11.8 a year later, so it’s not looking as good to me as International — although dividend yields are stronger at 3%.

Ryanair (LSE: RYA)(NASDAQ: RYAAY.US) shares remained flat for much of 2014, but since mid-October they’ve provided the biggest gain of the three, up 44% to €9.65. A hike in the airline’s full-year guidance in November gave the shares added impetus, and we’ve since heard of a 20% rise in December passenger numbers.

On the valuation front, Ryanair shares are on a forward P/E of 16, the highest of the three, dropping to 14 for the year ending March 2016.

Time to buy?

Oil-inspired profit rises can only really be a short-term measure, as even if the price does not pick up again soon the intense competition between the airlines will surely put downward pressure on ticket prices again.

Investing in airlines is not for the faint of heart, but if I had to pick one of these three it would be International Consolidated Airlines — it’s a big multinational and its strengthening recovery makes it look good to me on today’s very low P/E valuation, at least over the medium term.

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Indeed, at time of writing Robert Walters has jumped 11% after the company raised its full-year outlook for the third time this year. Additionally, Ryanair’s shares have gained 8.6% at time of writing after the company raised its 2014 passenger and profit guidance for a third time in three months. 

Profiting from economic growth 

Recruiter, Robert Walters has been able to benefit from the global economic recovery as the demand for skilled professionals increases. The company has hiked its full-year outlook three times this year so far, as a strong performance across all of its regions has helped to drive growth. 

Management now expects full-year profit to be “materially” ahead of market expectations. City analysts were expecting a pre-tax profit of £13.8m for this year, or earnings per share of 11.6p. However, now the company expects to outperform, analysts will have to tear up their estimates and start again. 

That being said, even though today’s news from Robert Walters is exciting for the company and its shareholders, the group’s shares look expensive at present levels. For example, the company currently trades at a forward P/E of 23.5, which is justifiable based on the fact that earnings per share are expected to expand more than 40% this year.

Still, it should be noted that Robert Walters’ business is highly cyclical, therefore the good times are unlikely to last for ever. With this being the case, a high valuation of more than 20 times forward earnings seems questionable. 

Discount boost 

Meanwhile, Ryanair has also upgraded its full-year profit goal for the third time this year. Management now believe that pre-tax profit for the 12 months to March 31 will be in the range of €810m to €830m, compared with €760m predicted just four weeks ago.

Management believes that a slowdown in the European economy could push people in its direction. What’s more, Ryanair has profited from its decision to appeal to business customers. Year-on-year Ryanair’s traffic gained 22% with load factors rising 7% to 88%. Seat capacity was up 13% for the month from a year earlier.

However, it seems as if investors are willing to pay a premium for this growth. Ryanair is currently trading at a forward P/E of 15.9, which could be too expensive for some investors. The company’s earnings per share are expected to expand 48% this year. So for growth investors Ryanair could be worth a second look. Earnings per share growth of 13% is expected next year.

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Management have “significantly raised” winter capacity and traffic growth objectives for its forward guidance, with the latter expected to grow by 12% in Q3 and 20% in Q4 — figures that Ryanair has described as “very ambitious targets during the weaker half of the year”.

Additionally, management have revised their passenger growth plans to double by 2024, to 150 million a year. The period also saw 57 new routes opened, and the company plans to capitalise on this as it went on to say:

“We believe it is time to capitalise upon the many opportunities available to us at both primary and secondary airports, to grow our route network and increase frequencies, in order to attract business traffic which tends to travel more during the winter period.”

Ryanair has also estimated that unit costs will fall by 4% in FY2015 as they are expected to be “positively impacted by this significant H2 traffic increase”, leading to a revised full-year net profit guidance of between €750m and €770m, a big leap from the €650m previously anticipated.

Key financial figures included a 32% surge in net profit across the first half, to €795m from €602m in the same period last year. Revenue lifted by 9% to €3,537m (H1 2013: €3,255m), while the company saw a 4% lift in passengers to 51.3 million.

CEO Michael O’Leary commented:

“While partially due to the presence of Easter in Q1 and a weak prior year comparable, we have also enjoyed a strong summer thanks to our strategy (announced Sept. 2013), of raising forward bookings and improving our customer experience which has delivered higher load factors and yields.”

Shareholders won’t be too upset at the confirmation of a €520m special dividend being approved for February, amounting to €0.375 per ordinary share. 

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