Description

“It’s the capacity, stupid!”

For the most part, I’d argue that the airline industry (particularly short-haul) operates like most commodity industries.  When times are good, everyone thinks it’ll last forever, and airlines trade at a premium to the value of their fleet. The airlines react by aggressively adding capacity.  Eventually, these capacity additions overwhelm demand, forcing airlines to endure some combination of lower load factors and lower ticket prices, resulting in lower profitability.  Sentiment sours, and airline valuations approach (or even go below) the replacement value of their fleets. Airlines eventually respond to weak profitability by slowing capacity growth.  This of course results in some combination of rising load factors and higher ticket prices, which leads to higher profitability, and the cycle repeats itself.

At the present time, I believe we are in the early innings of the cycle for European short haul carriers.  As I’ll document below, most carriers are meaningfully trimming their capacity growth plans for the next few years.  I expect this to result in continued improvement in European airline profitability/sentiment/valuation from here. Therefore I recommend owning shares of easyJet.

easyJet Company Description:

easyJet is the second largest low-cost carrier (behind Ryanair) in Europe.  Its revenues are split 44% from the UK, 31% from Southern Europe, and 25% from other destinations.  The current fleet is 331 Airbus planes, 70% of which are owned and 30% of which are leased. Net debt is minimal, and the company has no material pension obligations. 

Although easyJet is an LCC, the customer experience is not quite as harsh as Ryanair.  And unlike some of its LCC competitors, easyJet often flies out of 1st-tier, slot constrained airports:

*Data is LTM as of 9/30/19 with exception of SAS (7/31/19)

A Brief History of the European Short Haul Airline Industry from 2005-2019:

Why European Short Haul Airline Profitability Should Improve from Here:

The “Big 5” among intra-European airlines currently control >60% of the market – Lufthansa accounts from ~16% of capacity, Ryanair 15%, IAG 12%, easyJet 11%, and AirFranceKLM 9% (data from IAG 2018 Investor Day Presentation).  How are each of the Big 5 adjusting capacity right now in light of depressed returns?

Importantly, air travel demand is a secular growth story – European air passenger volume has grown at a 5% CAGR over the last 20 years.  Therefore when capacity growth is running in the low single digits, as current capacity expansion plans imply, then demand typically exceeds supply, to the benefit of the airlines.

What This Means for easyJet:

With the rationalization of European capacity, I expect easyJet per-seat profitability to rebound substantially from here:

Although easyJet’s valuation (as measured by P/B) has already improved substantially off the 2019 bottom, it still has a ways to go as profitability improves:

*Airlines are seasonal businesses, and therefore BV/share for an airlines has a seasonal pattern.  To adjust for this, when calculating P/B for easyJet above, I used average BV/share for the last 2 semi-annual periods.

Keep in mind that although the European airline industry remains cyclical, it is becoming more consolidated over time.  The US airline industry consolidated substantially over 2009-2013 (Delta combined with Northwest, United combined with Continental, Southwest combined with AirTran, American combined with US Airways) as the share of capacity controlled by the top 5 carriers went from ~55% to over 85%.  As a result of this consolidation wave, the US airline industry underwent a step change in profitability:

*Profitability data from IATA

The European airline industry isn’t as consolidated as the US, but it’s getting there:

For that reason, there’s a good chance that the cyclical peaks and troughs in European airline profitability will both be higher going forward than they have been in the past….

Why Own easyJet Instead of Other European Airlines?

I prefer the LCCs (easyJet, Ryanair, and Wizz) to the legacy players (IAG, Lufthansa, AirFrance KLM) because, for the most part, the LCCs generate higher profitability and tend to compound earnings and book value per share higher than the legacy players (time is your friend with the LCCs more so than it is with the legacy players).

As I understand it, US shareholders have been unable to own Wizz since April of 2018 (and there isn’t an ADR), so for US investors, that makes it a non-starter.

I like Ryanair a good bit here too, but when I look at valuation, I see more upside from current levels for easyJet than for Ryanair.  Also, from a VIC perspective, Ryanair has been written up a number of times, but to my knowledge, easyJet hasn’t been.

Risks:

Hard Brexit:

• Hard Brexit would likely negatively impact UK travel demand (44% of easyJet revenue)

• easyJet has set up subsidiaries and enacted share ownership restrictions that should allow it to continue operating throughout Europe even in the event of a hard Brexit, but conceivably there could be difficulties for airlines operating flights between the UK and EU in a particularly mess and acrimonious Brexit scenario

• In a hard Brexit scenario, there is a chance that, to satisfy EU airline ownership rules, easyJet would have to curtail the voting rights of non-EU shareholders ( http://corporate.easyjet.com/investors/shareholder-services/eu-share-ownership - long story short, EU rules require that airlines operating in the EU must be majority owned by EU nationals.  Currently 49.9% of easyJet’s shares are held be EU nationals, excluding UK nationals. After Brexit, should easyJet still not be above 50% EU ownership, the easiest way to reach compliance would be to temporarily suspend voting rights of non-EU shareholders on a “last in, first out” basis)

Oil prices:

• Airline stocks definitely react in the short-term to oil price movements (the European airline stocks have all been down somewhat in reaction to the recent Iran news)

• easyJet has hedged 74% of their fuel needs over the next 6 months, 58% for their FY ending 9/30/20 and 45% for their FY ending 9/30/21 (Ryanair is a more aggressive hedger, but I believe both easyJet and Ryanair hedge more than most of their counterparts – therefore a modest increase in oil prices could benefit Ryanair and easyJet competitively)

• Over anything longer than the short-term, I view oil prices as a pass-through item for airlines that is ultimately borne by the customer

Macro:

• Should the European economy weaken, softening demand could more than offset the deceleration in supply

Environmental taxes/regulation/activism:

• “Flygskam” (flight shaming) movement may arguably be depressing air travel growth in Sweden and could spread

Catalyst

Evidence of continued improvement in profitability