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Easyjet – Are the turbulent times set to continue?

Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.


Easyjet has had a turbulent year during which it has seen its share price almost cut in half. It’s hard to believe the shares were priced at £16 in February of last year, today they are trading below £10. The perfect storm of decreasing fairs and increased costs have seen the sellers take charge in recent months, but could we be near the bottom? After the recent Q1 trading update I take a further look at this unloved share and assess whether Easyjet’s share price will return to flying high or whether there is more turbulence to come for shareholders.

Quick Facts

As at Wednesday 1st February 2017:

Current Share Price 939.3p
All Time High 1915p, April 2015
52 Week Low/High Low 873.00 on 17th Oct 2016
High 1,601.00 on 1st Feb 2016
Market Capitalisation £3.77bn
Enterprise Value £3.56bn
Net Cash/(Debt) £202m -Sept 2016 Results
P/E and EPS 8.78 / 107p – Sept 2016 Results
Dividend Yield 5.73%

What has gone wrong for EasyJet?

Easyjet perhaps needs no introduction, it is one of original budget flight operators. The company operates 820 routes across europe and the near east with over 250 aircraft on its books, either leased or owned. The financial years 2011 to 2015 were very good for EasyJet, posting growing revenues, earnings and operating margins as illustrated in figure 1 below.

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Figure 1 – Source: Easyjet, Shareinvestors.co.uk

The most recent financial year though, ended September 2016 showed an end to that trend. Revenues continued to grow but margins and consequently earnings dropped. The reason? Easyjet had been hit by two factors simultaneously, both declining revenues and an increasing cost base,  a situation no company wants to be in.

What has happened to EasyJet’s Revenues?

Whilst top level revenues have been growing year on year for a number of years the actual revenue per passenger has been declining fairly rapidly since 2013, with the revenue per Km descending even more rapidly. See Figure 2 below.

ezyhistoricrevs
Figure 2 – Source: EasyJet, ShareInvestors.co.uk

The budget airline model is continuing to be extremely popular and the major airlines and other entrants have taken note of this. To give just a few examples; the big players such as IAG, of which BA is a member has started to increase its offering in this area, not to mention the continued strength of Ryanair and two ‘new’ emerging budget players Wizz and Norwegian all adding capacity. It’s also worth noting that Norwegian also has somewhat of a USP in its long haul transatlantic offering too, particularly as this can add transit traffic to its short haul services. It’s no surprise then that with all this increased supply that prices have started to fall.

As a side note, for the year ended September 2016 Easyjet still actually manages to generate the most revenue from passengers per each KM flown though when we compare to the core competitors. Norwegian has the highest overall revenue per Passenger, being explained by its budget long haul flight offering. See figure 3 below:

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Figure 3 – Source: Companies, Shareinvestors

What is behind the cost increases?

The declining revenues are not necessarily an issue in itself, growing capacity afterall should theoretically lead to economies of scale, indeed in 2015 Easyjet was able to strengthen its margin despite falling ticket prices. Things though started to deteriorate in 2016 with margins dropping from 14.7% to 10.7% year on year, see Figure 4. The most recent quarterly result for EasyJet showed an even worsening picture and outlook. Costs were higher than revenues and thus margin was now in negative territory. It is worth noting though that Q1 covers the period September to December, this is traditionally the slowest quarter for the aviation industry and thus is unlikely to represent the full year picture. The company still expects FY17 to be profitable, more on that later though.

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Figure 4 – Source: Easyjet, ShareInvestors.co.uk

To understand the drivers of this headline cost increase let’s take a look a deeper look at the cost base in Figure 5.

ezj-cost-mix
Figure 5 – Source: Easyjet, Shareinvestors.co.uk

It is pretty clear where the drivers of the cost increases are, you can hopefully see it is the ‘airport’ and ‘other operating’ categories. Much of these costs are euro denominated and hence are sensitive to the collapse in Sterling’s value post BREXIT. Fuel is also notable, whilst the cost has declined moderately, this is though against a backdrop of an oil price which has fallen by 50% over the same period. Unfortunately for Easyjet fuel is priced in $ so has been unable to fully benefit from the fall in price, it’s forward hedging programme also means there is a lag in the benefits of a lower spot fuel price.

This is not true of EasyJet’s main competitors though as figure 6 shows below. This shows how the European carriers, particularly Wizz and Ryanair have been able to control the cost and a good chunk of this is down to the effects of foreign currency. The result? Wizz and Ryanair are still posting margins in the mid/high 20% compared to EasyJet’s margin of 10.6%.

I must confess I have been a little lazy in how I have calculated figure 6, I have simply taken the last reported results from each competitor, which in the case of Ryanair and Wizz was the last half year and for Norweigan the last quarter. This overly punishes Easyjet which has its full year results of 2016 included, this obviously includes the traditional weak period of October through March. That said I don’t feel it materially changes the conclusions of the article.

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Figure 6 – Source: Companies, shareinvestors

So what are the prospects for a turnaround in the share price?

Based on guidance from Easyjet I have estimated in Appendix 1 that the company is still likely to generate almost £250m of earnings for FY2017, putting the company on a P/E ratio of around 14. This is not too shabby, especially when you consider a dividend yield of over 5.5% too. Ultimately EasyJet is a fundamentally good business which is having a dip in fortunes. Revenue pressures are unlikely to subside so cost control is key and this is a function of two parts, a) Real Cost Savings, i.e. on a constant fuel and currency basis b) Macro picture.

On point a) Management are focusing on delivering cuts, but are they succeeding? Figure 7 shows the declining cost per seat on a constancy currency basis, i.e. with the effects of FX stripped out. I’ve also adjusted for general inflation. This looks impressive at first glance showing a reduction in cost per seat of around 10% in the past three years. There is though another macro theme here to consider, the declining fuel price. I’ve therefore also plotted the rebased fuel price adjusted to GBP over the same period (orange) in figure 7. Given that fuel makes up around 1/3rd of Easyjets costs I assumed Easyjet can only access 1/3 of the gains, this is therefore also plotted in Figure 7, in grey.

The result now seems less impressive, figure 7 shows EasyJet’s cost reductions were actually lagging behind the fuel prices reductions from 2014 to 2016. This of course can be explained by forward deliveries of fuel, Easyjet hedges forward between 45%-65% of its fuel requirements 24 months out. In Q1 2017 though the cost savings are now below the reduction in fuel prices which is encouraging. In the analyst call last week, management state they have delivered ‘lean cost savings’, but warned much of these are being eroded by increased passenger claims against disruption. Nonetheless green shoots and management will continue to focus on costs, including looking at the organisation.

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Figure 7 – Source: EasyJet, Boe, ShareInvestors

What is more likely to improve profitability though is point b) from above, the macro situation. Easyjet has stated in its guidance that for every cent strengthen/weaken in the $:£ it can expect a +/-  £2.4m on the full year pre tax result and +/- £0.6m on a 1 cent movement in the €. Note, the average GBP:USD was 1.24 in Q1 so I assume this is the benchmark.

I personally expect sterling to strengthen, a combination of BREXIT certainty in the UK, UK interest rate increases and Trump uncertainty in the next 2-3 years could see Sterling strengthen back up towards $1.50, this would add £100m to earnings. This would place EasyJet on a P/E of around 9, deep in value territory. If management do deliver on real costs savings then we can expect further upside.

Are there other Risks to consider though? What about the balance sheet?

The balance sheet was strengthened at the start of the year, €500m was borrowed for 7 years at an extremely attractive fixed rate of 1.125%. This is a much better deal for Easyjet than for the lender, perhaps showing how desperate lenders of Euros are given the low yield on the currency. The issuing of debt in Euros will no doubt also assist in EasyJet’s hedging programme. Total debt at year end is expected to be around £1bn, assuming no further bumps in the road. Interest cover should not be a problem for the foreseeable future, but is the dividend safe?

The operating business of Easyjet is generating plenty of cashflow, covering the dividend twice over (see appendix 1). However, Easyjet is committed to plenty of CAPEX to upgrade to a more fuel efficient fleet, expecting CAPEX of £1bn in both 2018 and 2019. Free cash flow after capex will not be sufficient to cover dividends. However, Easyjet has access to up to £3bn of loan notes and has undrawn access to 2/3 of this facility. Gross gearing is expected to be around 27% at the end of 2017 and by the end of 2019 it’s likely to rise to 50%. This is a perfectly sustainable capital structure, assuming EasyJet can continue to borrow at around 1.5%-2% at a fixed rate. I therefore believe that assuming no worsening of the underlying business then the dividend is unlikely to be cut.

There are plenty of other risks though to contemplate, further supply and a reduction in demand could make the environment even more challenging. Easyjet was one of the few companies though that made profits in 2008/2009 and the budget sector is arguably less cyclical. That said this is not a risk to be ignored, all the main players are increasing capacity and thus even if demand holds up then I would be surprised if we see revenue per passenger increases for a while.

The recovery of oil price and the corresponding effect on jet fuel is another very tangible risk. The oil price is starting to head towards $60 as OPEC cuts supply. I would be very surprised though if we oil prices above $65 in the next two years, there is simply too much supply which becomes profitable at that level. The fuel price as at the end of December 2016 was $533 per Mt, Easyjet has hedged 83% of  2017 at $613 a MT and 54% of 2018 at $513 Mt. That said the unhedged position will still affect the pre tax earnings by +/- £3m for each $10MT change in the fuel price.

Further currency weakness will of course also be an issue, but I can’t see much more downside here. In fact Easyjet’s european competitors are posting some exceptional margins but they are not immune either from the macro picture, the Euro may face headwinds this year depending on the economic and political success of the zone. This has the potential to damage margins of the competitors, Easyjet on the other hand standing to benefit from any weakening of the Euro.

Summary

BUY – Target 1070 – 21% upside, includes dividend

With a dividend yield of 5.73% Easyjet is starting to have appeal against the FTSE100 yield of 3.73%, also against Ryanair and Wizz who are do not pay dividends. I can’t see a threat to EasyJet’s dividend in the next few years in all but the most apocalyptic scenarios. The forward PE ratio I expect to be around 14 but this could fall below 10 on a strengthening pound and further real cost savings. There are though plenty of risks to ponder, including further competition suppressing prices and further macro headwinds relating to currency and fuel prices. On balance though I see more upside than downside and it’s also worth considering that Easyjet is a particularly good hedge if you hold lots of stock whose earnings are primarily in US$, especially oil companies, of which I have a reasonable exposure in my portfolio.

Appendix – FY2017 ShareInvestors Earnings Calculation

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Disclaimer – I have long positions in Easyjet equal to 2% of my NAV. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.

This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.

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