Saturday, 25 March 2017

Easyjet Plc (LON:EZJ): Does it constitute a value investment?

Does the old joke hold true 'how to make a billionaire a millionaire; buy an airline' or does Mr Buffet's recent foray into the industry show we have moved on from having an industry which has  "eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You've got huge fixed costs, you've got strong labor unions and you've got commodity pricing."

Remember this guy?
Well in this example I want to do a bit of an overview of Easyjet. The company has some advantages over Buffet's old view because labour unionisation is less of a problem as are legacy costs. Easyjet is more like a flying bus service. The company has excellent routes and is a good operator.

I always fly Easyjet over Ryanair for two reasons (a) it has a website a normal human can use [which secures a booking] and (b) it flies to places I actually want to go on holiday (who flies to Poznan? Or Dinard?). 

However is Easyjet a good investment?

Well I got to looking at it due to the share price fall with the shares down 50% from their 2015 peak and 33% down since the 'Brexit' vote. Trading at 9.4x trailing P/E with around a ~5% potential yield things look relatively attractive.

The reason for the poor price performance is a combination of (a) deteriorating fundamentals (b) political risk. 

The driver of (a) is principally weaker sterling following on from (b). Margins are falling, demand is lower and with a mismatch between a sterling dominated revenue base (of Brits trying to escape terrible weather) and a Euro exposed cost base and Dollar denominated fuel puts a crunch on Easyjet. So the macro factor most likely to influence Easyjet is the strength of the Sterling. Which is at a 30 year low vs the dollar and significant low vs the Euro at the moment. 

The problem with (b) is Easyjet is exposed to the fallout from Brexit via (a) but also via regulatory impediments. Just this week ;

"EU chiefs have warned airlines including easyJet and Ryanair that they will need to relocate their headquarters or sell off shares to European nationals if they want to continue flying routes within continental Europe after Brexit.
Executives at major carriers have been reminded during recent private meetings with officials that to continue to operate on routes across the continent – for instance, from Milan to Paris – they must have a significant base on EU territory and that a majority of their capital shares must be EU-owned." -The Guardian 
So there is risk here beyond the merely operational problems associated with the currency devaluation and weaker consumer confidence. Moving your HQ is not too hard but moving your share capital might be a bit trickier. Still Easyjet may be able to fiddle it if the founder's shares are classified as EU, in fact Ryanair have more shares held by UK nationals at the moment.

Value investments tend to arise during these periods of regulatory or other uncertainty. This can make an attractive entry point into a good quality business but not if the feared catalysts prove to be worse than expected of course!

These two hangover are likely to continue to weigh on the shares in the medium term from a qualitative perspective. Easyjet becomes the 'maybe Brexit won't be that bad' sentiment proxy (alongside GBP trades).

What about the fundamentals?

Well Easyjet appears to be a structurally sound business facing a cyclical downturn. I would hazard a guess that going concern is not an issue as Easyjet runs net cash (albeit leases act a bit like debt). Rather investors are essentially abandoning the stock due to a weaker medium term earnings outlook.

Thinking like Mr Buffet; Does this company have a durable competitive advantage? I would say yes due to lower costs than legacy carriers and the barrier to entry of slots across the best EU airports - but loss of continental Europe business could mean loss of slots and a permanently impaired growth trajectory and fleet reduction. I will assume the company adapts to the new environment rather than just let's this happen to them.

My main issue is simply valuation and the cycle. Easyjet margins and return metrics hit their peak in 2015 and funnily enough so did the share price at around £19 a share! Margins and returns have since been trending down following Brexit and presumably a weaker consumer confidence. Those margins have also been boosted by lower fuel costs since 2014:

Amiable Minotaur Model: Margins comparison

Now looking at the performance of margins in the 2008/9 crisis period Easyjet is still way more profitable (and a lot larger) than it was then - so I see a limited downside risk to those levels. Still I feel that looking at it cyclically we are only one year into Easyjet's downturn and I think it will take at least another 6-12 months before the comparison basis with a weaker sterling washes out and potentially earnings could start to improve again.

Valuation guideline; A 10 year average ROA is 6.3%. This is a bit pessimistic as Easyjet ROA peaked at 11.4% in 2015 but troughed at 1.9% in 2009. However I feel in future returns will be more  moderate due to potentially higher jet fuel costs and a lower growth trajectory for the company as there are only so many slots you can fill, routes you can fly and sky space you can take up. 
Amiable Minotaur Model: Returns comparison

Revenue growth has stagnated and slowed rapidly since 2013 which illustrates my point about future growth opportunity: 

Amiable Minotaur Model: Revenue Growth & Absolute

So ROA will likely be lower in future than the peak - to give Easyjet some leeway let us say it will be 8% as they are better operators now than 10 years ago. Well at the £5.5bn total assets of Easyjet at year end 2016 I suggest a normalised earnings of around £440m across the cycle. If we put today's  10x earnings multiple on that level I estimate an intrinsic value around £11 per share which offers a 10% upside from today's levels. 

[Why 10x earnings? I would not want to pay a lot more than that for a company with high operating leverage, high capital intensity and low future growth prospects - i.e a commodity business albeit an operator with a low cost advantage.]

So does this make me want to buy Easyjet. Maybe. But not yet. I think regulatory headaches and Brexit noise could drive the stock lower. I dont see a recovery in earnings growth in the medium term and I dont think the shares give enough of a margin of safety at these levels to offer out sized future returns. I think around the £8.50-£9 a share level the risk/return would be more promising. If I were an Easyjet shareholder I would probably keep the shares for their healthy dividend yield in the ~4 to 5% range - but as a potential new entrant I would bide my time.

Essentially on a 'Buffet style' view Easyjet seems to offer a fair price today at these levels for an average business i.e a glorified commodity. If I am buying an average business I want to pay a discounted price.

Disclosure: I have no position at present in the shares of Easyjet Plc.

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