Low-cost airlines

Low-cost airlines The Sky's the Limit! Airlines Airlines in operation in Europe (IATA) Low-cost airlines LCC European market share (2006 BGe) Number of departure worldwide by 2010 Of which internal flights within Europe Of which internal flights within Asia Of which internal flights within US Of which intercontinental and other flights Fuel bill as a % of opex in 2006 Fuel bill as a % of opex in 2007e Sector ratings Market cap. (m) Ryanair (EUR) easyJet (p) SkyEurope (EUR) 9,010 2,863 183 Current price €5.83 684p €4.70 Target price €7.50 842p €7.70 29% 23% 64% Upside 98 50 30% 2.5bn 591m 678m 552m 679m 24% 26% 9th March 2007 In the following report we demonstrate why certain LCCs (low-cost carriers) will continue to enjoy significant improvements in profitability in the years to come. We initiate coverage of the “best in class” candidates: Ryanair (as the ultimate low-cost play); easyJet (for its emphasis on service); and SkyEurope (the Eastern European specialist). Our increased confidence in future profitability is linked to the fall of more than 25% in the oil price since August 2006, and is based on conservative estimates for volume growth and efficiency improvements. In this respect, we envisage market share gains for lowcost carriers in both the business and leisure segments. The low-cost carrier business model is the only viable and sustainable solution in both short-haul and air transport businesses. Our analysis shows only the most dominant players, with the necessary economies of scale, will survive the relentless competition. The shift from a “low fare” concept to an “added value” one, with the addition of on-line check-in facilities and increased hand baggage allowances, illustrates how the low-cost sector manages to re-invent itself and attract new categories of clients. Our preferred plays Ryanair, easyJet and SkyEurope are all “quality” companies, justifying valuation premiums. They all enjoy: 1) leadership positions in their respective markets; 2) outstanding contracts with aircraft suppliers; 3) sufficient cash for growth; and 4) the ability to improve margins. Our in-depth research concludes there are significant gains to be made from investments in Ryanair (29%), easyJet (23%) and SkyEurope (64%). 21 0 1 90 1 70 1 50 1 30 10 1 90 Jan- M ar- M ay- Jul05 05 05 05 Sep- No v- Jan- M ar- M ay- Jul- Sep- No v- Jan05 05 06 06 06 06 06 06 07 DJ EURO STOXX50 DJS TM A irlin Alexandre Boukhari: +33 1 56 68 75 01 aboukhari@bryangarnier.fr Low-cost airlines P as senger r ev enue / P ass enger v ol ume gr owt h M ar gi n 400 350 300 16. 0% 14. 0% 12. 0% 10. 0% Revenues, US$ billion Passenger Cargo Traffic volume growth % Passenger growth, % Passenger numbers, millions Cargo growth, % Freight tonnes, millions World economic growth % GLOBAL COMMERCIAL AVIATION KEY FIGURES 2001A 2002A 2003A 2004A 308 306 322 379 239 238 249 294 39 38 40 47 2005A 413 325 50 2006E 450 359 54 2007E 466 373 56 250 200 150 100 8. 0% 6. 0% 4. 0% 2. 0% 0. 0% -2.9% 1,640 -6.3% 28.8 1.6% -2.5% -2.6% 319 43 13.5% 24.7 30.5 11.8 276 38.5 1.7% 4.4% 63.9% 59.4% (11.8) -3.8% 0.1% 1,639 6.1% 31.4 1.7% -2.4% -4.6% 311 40 12.9% 25.1 29.1 11.3 271 37.8 -1.7% -2.4% 62.9% 60.8% (4.9) -1.6% 1.5% 1,691 4.3% 33.5 2.6% 2.7% -4.9% 323 44 13.6% 28.8 34.7 11.0 279 38.2 1.1% -4.3% 63.3% 61.0% (1.5) -0.5% 13.9% 1,888 11.9% 36.7 4.1% 3.9% -2.6% 375 61 16.3% 38.3 49.7 10.6 314 38.9 1.9% -1.9% 63.9% 62.5% 3.3 0.9% 7.3% 2,022 2.7% 37.7 3.6% 3.1% -1.3% 409 91 22.2% 54.5 71.0 10.4 318 37.2 -4.4% -5.6% 63.8% 62.5% 4.3 1.0% (3.2) -0.8% 5.6% 2,135 5.0% 39.6 3.9% 2.5% -0.1% 436 112 25.7% 66.0 84.0 10.2 324 36.1 -3.0% -3.2% 62.9% 62.8% 10.2 2.3% (0.5) -0.1% 5.0% 2,241 5.0% 41.5 3.1% -0.5% -3.6% 456 120 26.3% 61.0 n/a n/a 336 35.4 -2.0% -3.2% 62.1% 62.3% 10.2 2.2% 2.5 0.5% 50 0 2001A 2002A 2003A 2004A 2005A 2006E 2007E -2. 0% -4. 0% P ass enger P assenger gr owt h, % Fuel as % of opex / B r ent pr i ce evol ut i on 70. 0 30. 0% Yield growth % Yield growth, inflation/ex rate adjusted % Expenses, US$ billion Fuel % of operating expenses Crude oil price, Brent, US$/barrel Jet fuel price, Brent, US$/barrel Gallons used/100 Tonne Km performed Non-fuel Cents per Available Tonne Kilometre % change % change, adjusted for exchange rate Break-even weight load factor,% Weight load factor achieved, % Operating profit, US$ billion % margin 60. 0 50. 0 25. 0% 20. 0% 40. 0 15. 0% 30. 0 10. 0% 20. 0 10. 0 5. 0% 0. 0 2001A 2002A 2003A 2004A 2005A 2006E 2007E 0. 0% Fuel as % of opex B r ent pr i ce Description LCCs greatly contribute to enhancing the mobility of European citizens. They have achieved lucrative positions on several intra-community routes, forcing incumbent carriers to review their respective offers. This success is reflected in current prices, with Ryanair and easyJet’s valuation superior to that of both British Airways and Air France on a PE basis. . Net profit, US$ billion (13.0) (11.3) (7.6) (5.6) % margin -4.2% -3.7% -2.4% -1.5% Source: ICAO data for major categories to 2005. IATA forecasts 2006-2007 (December 2006) Last audited data released by the airlines RYA Fiscal year ended Mar-06 Key performance indicators Return on equity 16.5% Total sales (€m) 1,692.5 EBIT margin 22.2% Cost per seat (€) 32.3 Cost per seat excluding fuel (€) 21.3 Output measures Passengers (millions) 34.8 Number of aircraft operated 103 Number of aircraft BS 86 Number of routes operated 341 Staff number 3,063 Sector performance measures Load factor 83.0% Break-even load factor 68% Operated aircraft utilisation (hours per day) 9.6 Available seat kilometres (ASK) (millions) 39,070 Revenue passenger kilometres (RPK) (millions) 32,428 Average fare including ancillary services (€) 48.6 Cf. Appendix D (page 62) for Index of abbreviations EZJ Sep-06 10.1% 2,404.8 7.3% 56.4 41.6 33.0 122 44 262 4,359 84.8% n/a 11.6 37,088 31,621 72.8 SKY Sep-06 AF Mar-06 BAY Mar-06 LHA Dec-06 IBLA Dec-05 22.8% 4,929.0 2.4% 134.0 110.0 27.7 154 60 n/a 24,160 77.1% n/a 9.1 63,628 49,060 178.1 n/m 13.3% 22.5% 18.3% 158.6 16,942.0 12,292.0 13,475.0 -35.0% 3.8% 8.3% 6.5% 64.0 173.0 239.0 177.3 45.9 n/a 204.4 130.9 2.6 14 0 79 866 75.6% n/a 9.5 3,703 2,801 61.9 70.0 575 380 728 102,422 80.6% n/a n/a 234,669 189,253 242.0 35.6 284 207 n/a 49,490 75.6% 63% 10.1 147,934 111,859 345.0 53.4 430 351 n/a 93,541 75.2% n/a n/a 146,720 110,330 252.2 2 Low-cost airlines Historical context The airline industry as a whole, has had to adapt to a significantly changing environment over the past few years, characterised by the emergence of terrorist threats, the massive increase in oil prices, and more dynamic competition across regional and international markets. Very few players have emerged unscathed. The US players in particular, were knocked for six after 9/11 and the whole of the US industry suffered from 2001 till 2005. Even today, many are still struggling to regain profitability. European peers were quicker to react and adapted their strategies to cope with the harsh backdrop: massive restructurings, protection against increased kerosene prices via forward contracts, etc. In this way, many were able to return to profit in 2002, and are currently achieving record financial performances. Fortuitously, annual energy cost increases in excess of 20% since 2002, were offset, to a certain extent, by the impressive growth in international passenger traffic over period (circa 8 % increase p.a.). In this challenging landscape, the LCCs developed a new business model based on minimising operating expenses. The result, some have become the references in the huge European market, such as EasyJet and Ryanair. Reasons to be cheerful Despite the tremendous growth the airline industry achieved in 2006, we envisage a continuation of the positive demand environment in 2007. Since the European Union (EU) expanded in 20041, airlines have increased services to Central & Eastern Europe. All new members saw traffic increases of at least 10% in 2005. Most of this growth being between the old and new EU states. Generally, the ‘low-cost’ carriers, such as SkyEurope, vs. the historic network carriers, were most aggressive in launching new services. The EU is now expanding the single aviation market beyond its borders, signing agreements with Morocco, Turkey and the Ukraine for example. These deals are driving even more rapid growth in these geographies. 1 Ten new members: Cyprus, Czech Republic, Estonia, Lithuania, Malta, Poland, Slovakia, Slovenia Hungary, Latvia, 3 Low-cost airlines The need to be selective Although current valuations may appear high, our analysis shows the consensus is underestimating the growth potential for low-cost carriers. However, we stress that not all airline companies will survive. We expect the consolidation trend to continue over the next few years, with those companies able to attain dominant positions set to be the long-term winners. The airline industry is forecast to see a period of slower but more profitable growth over the next five years. Demand growth in the area of 4% will slow from the peak attained in 2004 and 2005, but will continue to boost airline revenues. Hence the need to invest in quality stocks, i.e. those with tangible earnings growth prospects, justifying valuation premiums. With this in mind, we initiate coverage of Ryanair, easyJet and SkyEurope, all of which exhibit strong fundamentals. Outright Buys BUY Ryanair, €7.50 target price With a 7% market share of European flights, Ryanair remains our preferred pick amongst the LCC. In the following section, we outline how management will pursue its growth strategy in a market which has yet to reach maturity. On the back of tight and efficient unit cost management, we argue that the “King of Low-cost” will take advantage of lower oil prices together with the improvement of revenues per passenger. easyJet also exhibits strong potential. Although the company does not share the same track record as Ryanair in terms of cost cutting efficiencies, we nevertheless demonstrate large areas of potential for improvement (which are currently unaddressed). In addition, easyJet is evolving from a classic “lowcost” model to a hybrid “good value” play, allowing the company to achieve higher revenues per passenger. Last but not least, SkyEurope has achieved phenomenal success in a matter of only a few years, with its dynamic management exploiting a gap in the market to become Slovakia’s national airline by default. This launch-pad has enabled the firm to create hubs across Eastern Europe, and succeed where other larger players such as easyJet previously failed. With the focus on achieving profitability, we predict the corner will be turned at the EBITDAR and EBIT levels by September 2007 and September 2008 respectively. BUY easyJet, 842 pence target price BUY SkyEurope, target price €7.70 4 Low-cost airlines External influences Oil price volatility - Within the low-cost model, jet fuel typically accounts for around 30% of total costs before depreciation and aircraft leases. The sharp rise in oil and jet fuel prices since 2003 accordingly forced airlines into adopting hedging policies in order to contain costs. In our model, we follow the evolution of the oil price depending on individual company hedging strategies: SkyEurope has hedged more than 90% of its jet fuel on a US$63/bbl basis for the fiscal year ending September 2007. easyJet anticipates its fuel bill will be higher for H1 2007 compared to last year, but will dwindle in H2 2007, and fall 5% in 2008. Ryanair has hedged its fuel consumption requirement to March 2007 on a US$73/bbl basis, limiting the positive impact of the recent price setback. However, H2 2007 will see the company significantly reducing its fuel bill. In addition, Ryanair has upgraded a large part of its fleet with “winglets” enabling lower fuel consumption. Fig. 1: Annual oil spot price evolution $ per barrel Oil price (Brent) Change 2000 28.4 2001 24.4 2002 25.0 2.5% 2003 28.9 15.6% 2004 38.2 32.2% 2005 2006e 2007e 2008e 2009e 57.6 50.8% 2010e 49.4 -7.5% 68.7 19.2% 64.0 57.4 53.4 -6.9% n/a -14.1% -6.8% -10.4% Source: Market consensus (September 2006) Dollar sensitivity - Airlines have significant US dollar exposure, with costs relating principally to 1). the purchase of aircraft, 2). aircraft financing, 3). maintenance and 4). fuel purchases. Whilst hedging activities provide a degree of protection against short-term exchange rate movements, the sector as a whole remains exposed to significant volatilities in the US dollar vs. local currencies, which could ultimately be material to the cost base. In the following table we outline the potential impact on 2006 EBIT margins of US dollar fluctuations against local currencies (€ for Ryanair and SkyEurope and £ for easyJet). Fig. 2: EBIT margin sensitivities to dollar fluctuation Dollar/Euro Actual 06 EBIT margin (€1=$1.26) €1=$1.20 €1=$1.25 €1=$1.30 (actual exchange rate) €1=$1.33 €1=$1.36 Ryanair SkyEurope 22.2% 20.2% 21.8% 23.4% 24.2% 25.1% -35.0% -38.5% -35.5% -32.8% -31.3% -29.9% Dollar/Sterling Actual 06 EBIT margin (€1=£1.77) £1=$1.60 £1=$1.80 £1=$1.98 (actual exchange rate) £1=$2.10 £1=$2.15 easyJet 7.3% 2.3% 7.3% 11.0% 13.1% 13.9% Source: Bryan Garnier & Company estimates 5 Low-cost airlines Environmental issues - Currently, we see growing public awareness of climate change and local air quality issues. This debate is most intense in Western Europe, increasingly focusing on CO2 emissions, instead of the traditional area of aircraft noise. Aviation contributes to an estimated 3% of CO2 emissions in the EU, a low proportion vs. road traffic (22%) and power generation (39%). Currently, there is no tax on jet fuel. The airlines are lobbying against a flat tax, arguing that high oil prices are already boosting investments in fuel efficient, low-emission solutions. Other external risks are a global economic slowdown, heightened geo-political tensions and upped security risks, plus a potential avian flu pandemic. 6 Low-cost airlines 1. Peer Group We have cross-checked our DCF valuation approach with peer group comparisons to LCC and network (flag) airline companies. The trading multiples are shown on Fig. 3.. Ryanair and easyJet are both trading at the upper end of the range vs. peers, with 2007 and 2008 PEs of 18-20x and 15x respectively. NB. Both Ryanair and EasyJet (which are comparable in term of size) are trading on similar ratios, but with premium to other airlines. We believe Ryanair and easyJet’s premium vs. peers is consistent given they are the undisputed fast growing LCC, generating huge operating margins vs. rivals along with an impressive free cash flow after capex. Fig. 3: Peer group comparison 2006 Company Low-cost Carriers Air Berlin easyJet Ryanair SkyEurope Sub-sector average (excl. SkyEurope) Network Airlines Air France-KLM Alitalia Austrian Airlines British Airways Iberia Lufthansa SAS Sub-sector average (excl. Iberia) Sector average (excl. Sky. & Iberia BG estimates easyJet Ryanair SkyEurope Source: JCF consensus and Bryan Garnier & Company estimates 1.3 4.0 1.4 11.5 14.2 -8.9 14.2 18.4 -7.8 23.7 22.5 -5.1 1.1 3.5 1.3 8.4 11.0 24.5 10.2 14.4 91.3 17.3 18.8 -36.5 1.2 8.0 12.6 11.5 0.9 5.1 9.0 12.1 0.8 5.7 12.7 9.1 0.6 4.0 8.5 11.6 33.24 0.96 10.34 5.21 3.28 20.33 100.00 EUR EUR EUR GBP EUR EUR DKK 8.954.3 1,330.5 334.0 6,002.5 3,109.7 9,309.8 16,450.0 3.8% n/a n/a 8.3% 2.4% 6.5% n/a 0.6 0.4 0.6 2.2 -0.3 0.5 0.4 4.3 4.6 3.9 12.3 -3.6 4.0 4.8 10.0 11.7 27.0 11.3 -6.9 8.4 7.9 9.9 -27.8 41.4 9.9 14.9 13.1 8.1 0.6 0.4 0.6 1.1 -0.3 0.4 0.4 4.0 3.3 3.4 5.8 -3.0 3.6 4.1 8.8 7.6 10.2 10.6 -5.9 7.5 6.5 8.4 24.0 9.8 8.7 12.8 12.0 6.6 2.2 12.6 12.4 16.3 1.5 7.3 10.0 13.0 14.90 6.84 5.81 4.50 EUR GBP EUR EUR 889.5 2,862.3 8,963.1 175.5 n/a 7.3% 22.2% -35.0% 0.6 2.6 3.3 0.9 5.4 21.1 11.3 13.6 9.5 13.2 14.6 -8.0 11.0 20.3 17.6 -6.5 0.5 1.2 2.8 0.6 4.0 8.2 9.7 3.5 7.2 9.8 13.0 23.5 8.3 15.4 15.3 225.0 Last price Curr. Market cap (m) EBIT margin EV/ Sales EV/ EBITDA 2007e EV/ EBIT P/E EV/ Sales EV/ EBITDA 2008e EV/ EBIT P/E 7 Low-cost airlines 2. Low-cost gaining the upper hand LCCs have achieved the greatest market penetration in the UK The market share of low-cost carriers in Europe has soared over the past three years, currently reaching circa 20-30% (depending on the definition of LCC). According to EUROCONTROL analysis, in the last 12 months the low-cost carriers added 2.4 percentage points to their market share through rebranding and organic growth. The UK is their biggest market, with 32% of flights now operated by low-cost carriers. This amounts to 21% of all flights in Poland and Spain. The number of low-cost airlines in Europe is now 50, down by 2 since last year, with low-cost companies operating out of 25 European states. The number of flights operated by low-cost carriers increased 23% over the year to over 3,700/day in the first 5 months of 2006. There are now 15 lowcost operators with more than 50 flights/day, compared to 13 only a year ago. Central & Eastern Europe countries exhibit high growth potential Finland, Poland, Denmark and Latvia have seen low-cost market shares jump by more than 5%, but others, including Hungary, Slovenia and Greece have lost market share. A 2% point increase per year is the average, which is the same rate of market share growth seen in previous years. There is no apparent shift of low-cost flights from larger airports to smaller ones. London Stansted remains the airport with the largest number of low-cost flights, followed by London Gatwick, Dublin, London Luton and Köln/Bonn. Ten of the top 25 low-cost country-pair flows involve the UK, and account for 42% of all low-cost flights. Slovakia is the national market where individual flows are most dominated by low-costs. However, the biggest markets remain dominated by traditional carriers: out of the top 10 total country-pair flows in Europe, the low-cost carriers have the highest share in only one - between Spain and the UK. 8 Low-cost airlines 3. Airlines as a whole are under an environmental Damocles sword The European Commission presented a plan for reducing air travel’s growing contribution to climate change in September 2005. Aircraft are an important and increasing source of greenhouse gas emissions causing global warming. The Commission says the most promising way to tackle aviation emissions is to bring aircraft operators into the EU’s Greenhouse Gas Emissions Trading Scheme (ETS). The ETS sets an overall cap on greenhouse gas emissions, within which participating operators can buy and sell emission allowances as needed. This would create a permanent incentive for airlines to minimise their emissions. 3.1. Aviation’s contribution to climate change Aviation’s share of overall EU greenhouse gas emissions is still modest at some 3%, but emissions here are growing faster than any other sector and risk undermining progress achieved through emission cuts in other areas of the economy. EU emissions from international flights grew by 73% from 1990 to 2003. This increase could widen to 150% by 2012 unless action is taken. Such growth would cancel out more than a quarter of the 8% reduction in total greenhouse gas emissions that the Kyoto Protocol requires the EU-15 to achieve between 1990 and 2012. 3.2. The need for action CO2 emissions from domestic flights are subject to emission targets under the Kyoto Protocol, but international flights are not. The 6th Environmental Action Programme committed the EU to take specific action to reduce greenhouse gas emissions from aviation if no such measures were taken by the International Civil Aviation Organization (ICAO), the responsible international body, by 2002. ICAO has not taken any such action. It has, however, endorsed the concept of emissions trading. 3.3. Putting market incentives at the heart of a comprehensive approach Given the situation in ICAO and issues of cost-effectiveness, the Commission believes that bringing aviation into the EU ETS offers the most promising way to tackle aviation emissions. In preparing its strategy the Commission examined several other types of market-based solutions, including airline ticket or departure taxes and emissions charges, but concluded that these would be either less effective in environmental terms or less cost-efficient. The ETS, which currently covers around 11,500 industrial installations, enables participating operators to reduce their CO2 emissions in the most cost-effective way. Each operator receives a limited number of emission allowances, creating a permanent incentive to minimise emissions. These allowances can be traded on the market, thus giving operators the flexibility to choose the cheapest way to control their emissions. Bringing civil aviation into the scheme, would allow aircraft operators to benefit from this cost-effective approach, enabling them to trade emission allowances in an expanded market with industrial operators and other airlines as necessary. From an environmental point of view, the Commission believes the ETS should cover all emissions from flight departing from the EU, whether to another EU destination or a third country. EU and non-EU carriers would therefore be treated equally. Stern Review says aviation accounts for just 1.6% of greenhouse gas emissions 9 Low-cost airlines As part of its comprehensive approach to the problem, the Commission also advocates continuing or strengthening a range of other activities that could help limit emissions from aviation, such as improving air traffic management and continuing efforts to remove legal obstacles to the taxation of jet fuel. 3.4. Impacts Preliminary estimates based on our modelling exercises suggest that the impact on ticket prices would be modest, ranging between zero and an increase of up to €9 per return flight. With an increase of this magnitude, aviation demand would simply grow at a slightly slower rate than previously anticipated. Any effect on tourism or peripheral regions relying on aviation is therefore likely to be very limited. 3.5. Next steps The Commission is inviting the European Parliament and the Council to give detailed responses to the Communication. In parallel, the Commission will set up an expert working group of Member States and stakeholders under the European Climate Change Programme to consider certain issues in more detail and report back next year. Subsequently the Commission will present a legislative proposal to revise the ETS. The timing of aviation’s entry into the ETS will depend on how quickly the legislation is adopted and implemented. Some LCCs are already largely involved in the process, and are ready to include the aviation segment in the European Emissions Trading System as soon as possible 10 Low-cost airlines 4. Developments in Europe European demand is expected to increase 4% The demand environment remains positive for 2007 and 2008, building upon the strong increases in volumes witnessed in Q4 2006. On average, airlines benefited from the positive demand environment to increase yields, though some have already reduced yields through lower fuel surcharges as the oil price has eased. Looking ahead, the majority of airlines envisage unchanged in yields in 2007, though strengthening competition from LCCs will continue to place downward pressure on prices. Nevertheless, some airlines may still face higher fuel costs in 2007, as some older fuel hedging contracts expire, and could be renewed at prices still higher than the old contracts. 11 Ryanair Holdings The King of Low-Cost Target price € 7.50 / Current price € 5.83 Airlines Bloomberg Reuters High / Low (€) Market Cap (€ m) EV (2007 BG Estimate) (€ m) Volume 6m Avge (in '000 Shares) Free float EPS growth 06 -09e (restated) Gearing 2006 Dividend yield YE: 31 March Sales (€ m) % change yoy EBIT (€ m) EBIT margin EPS (€ cent) EV / Sales EV / EBIT P/E (x) PEG ratio (rest.) 2005 1319.0 23% 340.7 25.8% 36.8 3.3 12.9 16.4 0.5 2006 1,692.5 28% 375.0 22.2% 40.0 3.4 15.2 19.6 2.3 2007e 2,193.0 30% 481.5 22.0% 26.0 4.3 18.4 22.5 0.8 RYA LN RYA.L 6.35 / 3.16 9,010.2 8,857.0 4,545 (IR) / 8,148 (LN) 92% 25.8% -14.8% n/a 2008e 2,536.1 16% 609.2 24.0% 31.1 3.5 14.4 18.8 1.0 9th March 2007 Buy Ryanair’s “pure” model means it will be able to sustain growth over the long term. In our view, its ability to lower costs is a neverending story. We initiate coverage with a target price of €7.50, representing 29% upside. Strong Buy. With a market share of 7% of intra-European flights (30% of the low-cost carrier market share), Ryanair still has enormous scope for growth in a market which is far from mature. Given its solid financial position, there appear to be no obstacles to achieving its ambitions. Indeed, outstanding aircraft orders with Boeing indicate Ryanair will attain 10% of the European market over the medium term. We predict Ryanair will record its strongest sales growth for 4 years, in the fiscal year ending 31st March 2007. A good indication of this, is that management upgraded its net profit guidance twice in the 9month period ended 31st December 2006. Amongst the major low-cost carriers (LCC), Ryanair exhibits the best fundamentals, having cut unit costs faster than any other LCC or National carrier, while dramatically expanding passenger volumes. 230 21 0 1 90 1 70 1 50 1 30 10 1 90 70 Jan- M ar- M ay05 05 05 Jul05 Sep- No v- Jan- M ar- M ay05 05 06 06 06 RY4-DB Jul06 Sep- No v- Jan06 06 07 DJ EURO STOXX50 The strategy of not passing fuel surcharges onto customers has paid off, promoting significant market share gains for Ryanair. This is in stark contrast to the stance taken by European flag carriers in the light of soaring fuel prices. With aircraft deliveries expected up to 2012, we see Ryanair’s traffic doubling and exceeding 80 million passengers. In this context, Ryanair will be Europe’s largest airline by some considerable distance. Ryanair is the “best in class” in the LCC (low-cost carrier) segment, with an EBIT margin of 22.2% in 06 vs. an average of 6% for major European national airlines. BUY. Alexandre Boukhari: +33 1 56 68 75 39 aboukhari@bryangarnier.fr Ryanair Holdings 2004A Revenue / E B I T DA R M ar gi n 35. 0% 37. 0% 36. 0% 35. 0% 25. 0% 34. 0% 20. 0% 33. 0% 32. 0% 31. 0% 10. 0% 30. 0% 5. 0% 29. 0% 28. 0% 2004A 2005A 2006A 2007E 2008E 2009E 2010E Revenue gr owt h E B I T DA R mar gi n 2005A 22.8% 35.8% 36.9% (87.6) 0.5 2006A 28.3% 32.3% 10.1% 66.8 2.3 2007E 29.6% 31.4% 28.4% (141.0) 0.8 2008E 15.6% 34.4% 26.5% 74.0 1.0 2009E 17.1% 35.8% 25.1% 280.1 0.6 2010E 15.0% 36.1% 17.1% 422.3 0.7 30. 0% Growth Credentials Revenue growth EBITDAR margin EBIT growth Free cash flow PEG ratio Income statement (key data) Scheduled revenues Ancillary revenues Staff costs Fuel & oil EBITDAR EBITDA EBIT Net interest Tax Net income EPS (€ cent) Cash Flow Net income before tax Depreciation & amortisation Change in WCR Other Cash flow from operations Capex Cash flow from investing activities Change in financial debt Dividends Other Net cash flow CFPS Balance Sheet Tangible fixed assets Goodwill & intangible assets Inventories Trade debtors Cash and equivalent Other current assets Total Assets L-T debt other non current liabilities S-T debt Other current liabilities Shareholders equity Total liabilities & shareholders equity Ratios ROCE ROE ROA Gearing Interest cover Cap ex/depreciation P/BV EV / EBITDA EV / EBIT 27.5% 35.4% -5.5% 71.4 (1.2) 15. 0% 0. 0% E B I T gr owt h / E P S 40. 0% 35. 0% 30. 0% 25. 0% 20. 0% 15. 0% 10. 0% 5. 0% 0. 0% -5. 0% -10. 0% 2004A 2005A 2006A 2007E 2008E 2009E 2010E E P S (€ ) E B I T gr owt h 1 0. 9 0. 8 0. 7 0. 6 0. 5 0. 4 0. 3 0. 2 0. 1 0 924.6 149.7 (123.6) (175.0) 380.5 352.7 248.9 (23.7) (21.9) 206.6 27.3 1,128.1 190.9 (141.7) (265.3) 472.6 451.1 340.7 (29.3) (29.2) 280.0 36.8 1,433.4 259.2 (171.4) (462.5) 546.8 499.5 375.0 (35.7) (32.2) 306.7 40.0 1,849.0 344.0 (221.9) (667.3) 688.3 625.2 481.5 (28.3) (50.8) 401.1 26.0 2,135.0 401.1 (256.6) (694.5) 873.1 797.9 609.2 (60.1) (68.6) 480.5 31.1 2,497.2 473.8 (300.6) (772.9) 1,063.5 977.1 761.9 (64.1) (87.2) 610.6 39.5 2,866.4 549.3 (345.6) (879.7) 1,231.6 1,134.1 892.0 (62.9) (103.6) 725.5 46.9 Company description Ryanair began operations in 1985, and in the early 1990s became a 'low-cost' airline. Ryanair launched routes to continental Europe in 1997, and acquired Stansted-based low-fare operator buzz from KLM in early 2003. The Ryanair business model is based on many of the low-cost principles pioneered by Southwest. Ryanair is the biggest LCC in Europe in terms of passengers carried, profits, number of destinations served and market cap. As of Sept. 2006, Ryanair had 140 Boeing 737-800 on order, which will grow its fleet to more than 300 aircraft by the end of FY2012. In addition to scheduled revenues, it derives ancillary revenues from nonflight scheduled services, such as car hire, hotels and travel insurance, onboard sales and other ancillary products. 228.5 101.4 101.3 4.5 435.7 (364.3) 6.9 125.5 0.0 (5.8) 198.1 26.2 309.2 110.4 134.1 (11.4) 542.2 (629.8) 5.4 461.9 0.0 (31.0) 348.7 45.9 338.9 124.4 138.8 2.5 604.6 (537.7) 121.0 262.9 0.0 (84.5) 366.3 47.8 451.9 143.7 210.5 (45.9) 760.2 (901.3) 0.0 477.6 0.0 0.0 336.5 21.8 549.2 188.7 86.4 (65.3) 758.9 (685.0) 0.0 320.3 0.0 0.0 394.2 25.5 697.8 215.3 134.9 (82.9) 965.1 (685.0) 0.0 279.9 0.0 0.0 560.0 36.2 829.1 242.0 154.9 (99.2) 1,126.8 (704.5) 0.0 265.6 0.0 0.0 687.8 44.5 1,576.5 44.5 26.4 14.9 1,257.0 19.3 2,938.7 872.6 124.2 80.3 406.1 1,455.3 2,938.7 2,117.9 46.8 2.5 20.6 1,605.7 24.6 3,818.1 1,293.9 140.5 121.0 528.3 1,734.5 3,818.1 2,533.0 47.6 3.4 29.9 1,990.8 29.5 4,634.2 1,524.4 271.9 153.3 692.6 1,992.0 4,634.2 3,290.5 47.6 4.0 39.6 2,327.4 31.4 5,740.5 1,996.1 290.5 159.2 901.6 2,393.0 5,740.5 3,786.8 47.6 4.6 45.8 2,721.6 36.3 6,642.7 2,275.9 303.2 199.6 990.3 2,873.6 6,642.7 4,256.5 47.6 5.4 53.6 3,281.6 42.5 7,687.1 2,527.8 319.4 227.6 1,128.2 3,484.2 7,687.1 4,719.0 47.6 6.2 61.7 3,969.4 48.7 8,852.5 2,768.2 335.9 252.8 1,286.0 4,209.6 8,852.5 18.1% 15.3% 7.6% -20.9% 10.5 3.3 n/a 9.0 12.7 18.6% 17.6% 8.3% -11.0% 11.6 5.7 2.6 9.8 12.9 18.4% 16.5% 7.3% -14.8% 10.5 4.4 3.0 11.4 15.2 17.6% 18.3% 7.7% -6.4% 17.0 6.3 3.8 14.2 18.4 19.1% 18.2% 7.8% -7.9% 10.1 3.6 3.1 11.0 14.4 21.3% 19.2% 8.5% -14.6% 11.9 3.2 2.6 8.7 11.2 22.7% 18.9% 8.8% -22.1% 14.2 2.9 2.1 7.1 9.1 13 Ryanair Holdings 1. Investment Case What’s changed? 1. Oil price decline When oil prices started to surge, most airlines (and especially national carriers) managed to offload a significant portion of rising costs onto customers. However, Ryanair differentiated itself by guaranteeing there would be no fuel surcharges. With the oil price having enjoyed a retracement, we expect a slight improvement in short-term margins. This will lead to a limited positive impact however, as Ryanair has hedged a large portion of its fuel purchases (circa 90%) to 31st March 2007 at $73/bbl. Given significant competition in the sector, we assume almost half of the gain will be kept in-house, with the remainder handed back to customers. Over the medium-term (to March 2008), we anticipate a theoretical improvement on the 2007/08e EBIT margin of 1.8pp to 24.0%. 2. Development of ancillary revenues Management brought about an impressive increase in ancillary revenues in Q3 2006-07 (+61%), significantly higher than traffic growth (+19%). This increase does not include the forthcoming services development, relating to onboard gambling mobile phoning facilities, as well as a Ryanair Hotel. 3. Upcoming dividend plan Ryanair accumulated a war chest amounting to approximately €0.5bn as of December 2006. We understand the board is now considering different options, including the payment of aircraft with cash, share buybacks, or the payment of a one-off dividend. Even if the company is unlikely to introduce a regular annual dividend, a one-off cash distribution to shareholders seems a viable option. Although management has not specifically mentioned it, we believe cash could partly pay for an Aer Lingus takeover. Valuation Concerns over the expensive PE07 of 18x are overdone in light of our earnings growth projections. The over-riding positive for us are: 1). Ryanair is the leading LCC, 2). it exhibits impressive high profit margins, and 3). a strong balance sheet with a net cash position of circa €0.5bn as of 31st December 2006. On the basis of a March 2008 PE of 15x, and a PEG of 0.95, the stock appears very attractive. Our 18 month target price of €7.5 is based on a DCF model comprising a WACC of 8.8% on average, a beta of 1.4x and a terminal growth rate of 0.5%. Catalysts 5th June 2007 FY results for financial period ended 31st March 2007 will give management the opportunity to outline expected gains deriving from the drop in the oil price. Secondly, as Ryanair indicated its commitment to an Aer Lingus takeover, we anticipate a renewed offer, if the EU ruling due on 11th May gives the desired go-ahead. 14 Ryanair Holdings Difference from consensus Our target price is towards the upper end of consensus estimates, reflecting our higher than average outlook for revenues and operating margins, based on management’s ability to reduce costs further. Risks The main risks to our investment case are as follows: Yields decline faster than expected. At present, we foresee a total yield decline of around 5% for the fiscal year ending March 2007, and a stabilisation form 2007 onwards. Thereafter, we assume flat to slightly rising yields. If the proliferation of low-fare carriers continues over the coming years, and pricing wars escalate, all carriers will suffer, placing our valuation at risk. Costs per passenger are expected to decrease for at least the next 3 years, as the Ryanair model is based on scale benefits deriving from a larger fleet. Thereafter, we expect unit cost to stabilise. Any substantial deviation from this road map in either direction, could present up or downside risks to our valuation. In respect of regulation changes and labour issues, it is feasible that the EU (or any one of the national governments or unions) could take decisions adversely impacting the revenue generation ability or cost control standards currently adopted by Ryanair. This could jeopardise our medium-term margin assumptions. 15 Ryanair Holdings 2. Valuation 2.1. Share price Ryanair was included in the Nasdaq 100 index from Wednesday, 14th February 2007. This listing brings greater visibility and wider appeal to both institutional and private investors worldwide. Fig. 4: Ryanair share price performance 210.0 Ryanair share price fluctuation 190.0 170.0 150.0 130.0 110.0 90.0 Jan05 Mar05 May05 Jul05 Sep05 Nov05 Jan06 Mar06 May06 Jul06 Sep06 Nov06 Jan07 RY4-DB DJ EURO STOXX50 DJS TM Airlin Source: Thomson One Banker 2.2. Modelling and DCF valuation In building our model, we detail how revenues will evolve in respect to fleet and passenger growth, load factor improvements and sales per passenger thanks to inroads achieve in the development of ancillary services. In addition, we have built a cost and capex model that puts emphasis on the cost cutting strategy and economies of scale possible from an enlarged fleet. Our DCF model derives a target price of €7.5, indicating a potential upside of 29%. We valued Ryanair based on conservative assumptions. We have used an explicit forecast period of 10 years (up to 2016). The parameters used to calculate our weighted average cost of capital (WACC) are shown in Fig. 5. In our approach, we privileged a variable WACC, given the fluctuating debt over the period under review. Our average WACC is 8.8% (taxed WACC). We computed a composite beta of 1.4x in the context of a Bloomberg beta of 0.70x, economic and legislation risks. 16 Ryanair Holdings Our terminal value assumes a 0.5% FCF growth rate given the cyclical characteristic of the airline sector. We believe this to be conservative given our projections for capacity increases over the period. Fig. 5: WACC calculation Assumptions Tax rate Risk free rate Risk premium Beta Cost of equity Cost of debt After-tax cost of debt Average WACC (cost of capital) Source: Bryan Garnier & Company estimates 12.5% 3.8% 4.5% 1.4x 10.1% 5.3% 4.6% 8.8% Fig. 6: DCF model, FY06/07e-15/16e DVF Valuation (Euro m) Sales growth EBITDA margin Capex Free cash flow WACC Cumulative WACC NPV of FCF Total NPV Add: excess cash Add: financial investments Less: debt Valuation Number of shares outstanding (k) Theoretical value per share (€) 1,678 11,668 1,560 7.5 06/07e 29.6% 28.5% (901.3) (125.7) 9.0% 1.09 (115.3) 11,374 1,972 07/08e 15.6% 31.5% (685.0) 123.2 8.9% 1.19 103.7 08/09e 17.1% 32.9% (685.0) 331.9 8.8% 1.29 256.7 09/10e 15.0% 33.2% (704.5) 472.9 8.7% 1.41 336.5 10/11e 13.6% 33.3% (741.6) 587.4 8.6% 1.53 384.7 11/12e 12.5% 33.3% (741.6) 740.3 8.6% 1.66 446.6 12/13e 7.3% 33.4% (148.3) 1,369.7 8.6% 1.80 760.8 13/14e 3.2% 33.5% (148.3) 1,356.1 8.7% 1.96 692.9 14/15e 3.1% 33.5% (148.3) 1,402.9 8.8% 2.13 659.1 15/16e Term. Val. 3.1% 33.5% (148.3) 1,450.7 8.8% 2.32 626.3 0.0% 33.2% (148.3) 16,729.1 8.8% 2.32 7,221.9 Source: Bryan Garnier & Company estimates 17 Ryanair Holdings 2.3. Sensitivity The table below shows the effect of changes in the terminal FCF growth rate and beta on the target price. It illustrates that even using a more conservative terminal FCF growth rate of -0.5% and a beta of 1.6x (implying a WACC of 9.8%), we derive a fair value of €6.1, underlining today’s hefty undervaluation. Fig. 7: Sensitivity of our fair value (€) to terminal growth rate and beta Beta 1.10 -0.5% Terminal growth rate 0.0% 0.5% 1.0% 1.5% 8.1 8.5 8.8 9.3 9.8 1.20 7.7 8.0 8.3 8.7 9.2 1.30 7.3 7.6 7.9 8.2 8.6 1.40 7.0 7.2 7.5 7.8 8.1 1.50 6.7 6.9 7.1 7.4 7.7 1.60 6.3 6.5 6.8 7.0 7.3 1.70 6.1 6.2 6.4 6.6 6.9 Source: Bryan Garnier & Company estimates 2.1. Peer group comparison We have cross-checked our DCF valuation approach with peer group comparisons to LCC and flag airline companies. The trading multiples are shown on page 7 of this report. Ryanair is trading at the upper end of the range vs. peers, with 2007 and 2008 PEs of 18x and 15x respectively. NB. Both Ryanair and EasyJet (which are comparable in term of size) are trading on similar ratios, but with premium to other airlines. We believe Ryanair’s premium vs. peers is consistent given it is the undisputed LCC, generating huge operating margins vs. rivals along with an impressive free cash flow after capex. 18 Ryanair Holdings 3. More growth to come… 3.1. Further network expansion Ryanair operated 17 bases as of the end of September 06, offering short-haul “point-to-point” scheduled services to 123 cities via 750 daily flights over a network of 410 scheduled routes. The company intends to fly to 24 new cities, increasing the current number of routes by more than 100 within the next 6 months. Fig. 8: Growth relationship between passenger, sales and share price (rebased) 800 700 600 500 400 300 200 100 0 2000 2001 2002 2003 Sales 2004 2005 2006 2007e Scheduled passenger Closing share price Source: Ryanair and Bryan Garnier & Company estimates 3.2. One of the largest and newest aircraft fleet in Europe Ryanair has a very young fleet of Boeing 737-800, each with 189 seats. In October 2006, the 103 aircraft fleet had an average age of just 2 ½ years. In contrast to EasyJet, Ryanair owns the majority of its fleet, with 17% on operating leases as of March 2006. This strategy makes sense to us, given the company reported a net cash balance after capital expenditure of circa €570m for the financial year ended 31st March 2006. By investing in a fleet of brand new aircraft, valued at $10bn, over the past eight years, Ryanair has reduced its noise and CO2 emissions by almost 50%, on a per passenger basis. This is clearly a priceless strength in the current environment, where the impact of aviation on climate change is under constant scrutiny. Future fleet development is secured by 160 firm orders and 137 aircraft options. 19 Ryanair Holdings Fig. 9: Fleet and traffic growth from 2006 to 2012e 350 Number of planes (units) 300 250 200 198 150 100 103 50 0 2006 2007e 2008e 2009e 2010e 2011e 2012e 133 159 245 295 318 90 80 70 60 50 40 30 20 10 0 Passengers (millions) Traffic (in m. of passegers) Aircraft fleet Source: Ryanair 20 Ryanair Holdings 4. A model focused on cost reduction 4.1. A cost model deigned to beat the oil crisis The spectacular increase in the oil price since the beginning of 2002 was one of the main challenges for the airline industry as a whole. Over the past 6 years, the sector has had to negotiate a series of economic obstacles including: the development of the international competition; inflated airport taxes and the growth of the services clientele related costs. However, the over-riding negative was the cost of energy reaching a full 26 % on average of total operating expenses in 2006 (35% for Ryanair). As of 2001, Ryanair adopted a model focused on a cost cutting strategy which reduced operational expenses to the bare minimum. The company succeeded while implementing a couple of key measures, including the cut in distribution costs which may represents 6% for some companies such as British Airways while it is only representing 1% for Ryanair. The company also made large savings thanks to the generalisation of the distribution of the electronic ticket, nine times cheaper than the printed version. Despite a sharp increase in airport fees in Dublin and Stansted, Ryanair continues to pursue negotiations with airports to achieve a lower rise in airport costs vs. sales growth. 4.2. Reduced airport fees Ryanair operates almost exclusively from secondary and tertiary airports, with very low fees and the potential for negotiation. In contrast, rival easyJet typically operates from primary airports. A concrete example of the differences in fee structures can be seen at Bremen airport (secondary type airport). Here, there is a charge of between €3-5k for the clearance of a typical LCC aircraft (e.g. Boeing 737800). This clearance includes fees for take off, landing, parking, check-in, baggage processing, aircraft checks. Airport costs make up the lion’s share of total airline costs. In 2006 for example, this : amounted to €216m for Ryanair (16.4% of total operating costs), and €596m for EasyJet (26.8% of operating costs). The major difference in airport and ground-handling fees is mainly a consequence of the difference in the choice of airports and networks. Ryanair essentially uses secondary airports whilst easyJet is geared almost exclusively to primary airports, where costs are substantially higher . Secondary/regional airports are typically smaller, with volumes derived only from a handful of airlines, thereby enabling considerable negotiating power. In this respect, Ryanair typically manages to achieve an advantageous package of services including security, stand spaces, etc. for negligible sums while in return, still benefiting from faster turnarounds, better on-time performance and fewer lost bags. 4.3. Advantageous revenues per employee Employee expenses are also a significant cost, with Ryanair enjoying a clear unit cost advantage over competitors, and easyJet in particular. Although headcount expenses are roughly similar for both carriers, Ryanair uses fewer employees per seat than easyJet. This unit cost advantage in labour costs, 21 Ryanair Holdings is partly explained by its larger aircraft size (Ryanair’s Boeing 737-800 capacity is 189 seats vs. the 156 seats for easyJet’s A319). 4.4. New planes for additional cost optimisation Ryanair expects to drive down unit costs by circa 3% over the next three years, with the bulk of the reduction to be derived from its new Boeing fleet and related maintenance, marketing and negotiations with airports. According to new Boeing specifications, Ryanair expects to reduce: emissions by 50% per seat fuel consumption by 45% noise by 45%. 4.5. The lowest unit costs in the European airline sector Despite unfavourable changes in the fuel price, Ryanair still exhibits the lowest unit costs vs. peers. Fig. 10: Units cost comparison amongst leading European airlines in 2006 In € per seat Ryanair easyJet SkyEurope Air France – KLM British Airways Lufthansa Iberia Source: Company data & Bryan Garnier estimates Cost per seat 32.3 56.4 64.0 187.8 239.0 177.3 134.0 Cost per seat excluding fuel 21.3 41.6 45.9 146.4 204.4 130.9 110.0 For the fiscal year ending March 2007, the cost of carrying one passenger one seat kilometre (operating costs/ASK), is expected to rise by circa 10%, primarily because of higher fuel spend. Excluding fuel, we expect unit costs will remain stable. 22 Ryanair Holdings 5. Ancillary services: the second string to Ryanair’s bow Revenues from non-ticket sources, or ancillary revenues, have become an important financial component for low-cost carriers in Europe, and especially for Ryanair. They represented 16% of the total sales in 2006. The intention of Chief Executive Michael O'Leary, is to eventually offer “free” airline tickets, which will be compensated by the greater revenues produced by ancillary activities1. His stance reflects how Europe’s LCCs have replicated the Southwest Airlines model, providing overall value “a la carte style”, offering ultra-low fares and charging consumers for “frills” such as checked-in baggage. Ryanair’s home page offers a virtual shopping mall experience, with offers for car insurance, personal loans, pre-arranged airport parking, airport coach transfers, airport lounge access, co-branded credit cards, holiday packages, bed & breakfast stays, and golfing in Ireland. The airline has also turned its baggage service into a profit centre. Checked baggage can be pre-paid at the time of booking, at a cost of €4.50 per item, or €10.00 if paid at the airport. Like many other LCCs outside the United States, Ryanair charges an additional fee for payment by credit card. The fee for MasterCard and Visa charges is €2.50 per passenger per flight. The fee is lower for debit card transactions and is waived for infant travellers. Following on from its present policy of selling “scratch” cards, offering the chance to win a million euros, Ryanair’s next step will be to introduce in-flight gaming on all flights. Ryanair has joined forces with the UK online gaming website “jackpotjoy” and plans to provide the world’s first in-flight online gaming service. Passengers will be able to play Bingo and “instant-win” games, with the chance of winning a cash jackpot. They will also be able to play to win back the price of their flight. This hinges on Ryanair’s first priority, to be able to offer in-flight mobile telephony. Acording to current plans, passengers will be able to use their mobile phones to access online gaming facilities. That said, in-flight telephony is still months away, as mobile phone providers are still seeking the necessary approvals from regulatory bodies. Therefore, in-flight mobile phone use will not be rolled out before June or July 2007, and online gambling is expected to be launched a couple of months later. Fig. 11: Ancillary revenues per passenger for 2005 Airline companies Aer Lingus Air Berlin easyJet Ryanair SkyEurope Virgin Blue Source: IdeaWorks - October 10,2006 Ancillary revenues per passenger €5.99 €2.51 €4.37 €7.76 €4.38 €3.80 1 “A radical fix for airlines: Make flying free” Business 2.0 Magazine, March 31st, 2006 23 Ryanair Holdings 6. Potential Aer Lingus takeover? On 5th October 2006, Ryanair launched a €1.48bn bid for Aer Lingus. The cash offer to shareholders represented a premium of approximately 12% over the closing price (€2.8 vs. €2.5). The offer translated into a PE of 11.1x (Ryanair 2007 PE 17.6x). The Ryanair strategy is to expand, enhance and upgrade Aer Lingus’ operations with the ultimate objective of forming an “Irish” airline. CEO Michael O'Leary indicated to date that both companies would continue to operate separately, and compete vigorously in the small number of routes on which the two companies both operate (currently around 17 of the approximately 500 routes operated by the two). Combined, the two airlines would carry over 50 million passengers a year for an estimated turnover in excess of €2.5bn. A combined Ryanair-Aer Lingus operation would account for 80% of all flights between Ireland and other European countries. The takeover bid was opposed by the Irish government, which retains a key stake in the airline (28%), a staff trust (12.6%), the Aer Lingus management and trade unions. In total, the shareholders formally opposing the bid exceeded 45%. Management conceded Ryanair could not acquire more than 50% of shares, the minimum required for a takeover, without support from the trust. On 21st December, Ryanair withdrew its bid for Aer Lingus, with the intent of pursuing another bid in near term, once the European Commission finishes investigating the current bid. The EC has expressed concerns that the takeover would reduce consumer choice and increase fares. In the event of the transaction going through, we anticipate a slight decline in Ryanair’s share price as its operating margin could be temporarily eroded. However, we are confident that Europe's most rapidly expanding and most ruthless airline in terms of cost-cutting, will ultimately find the necessary solution to counteract any margin erosion. Fig. 12: Aer Lingus 2005 key figures (€m) Profit & Loss Turnover EBITDAR EBITDA EBIT EBIT margin Net Profit EPS (€ cent) Key statistics Passenger flown in thousand (scheduled) Passenger load factor Average number of employees Average number of aircraft operated Market capitalisation (€m) 8,044 81% 3,475 33 1,534 883.0 183.8 139.8 73.2 8.3% 72.4 25.3 2005 24 Ryanair Holdings 7. FY07 guidance upgraded twice Ryanair upgraded its FY07 guidance at both Q2 and Q3 stages. FY07 net profit initially forecast at €335m, was upped successively to €350m and €390m. In this respect, we anticipate a net result in the area of €400m, due to a better than expected yield in Q4. Taking into account the expanded aircraft fleet, combined with a sustained demand outlook, passenger volumes are expected to grow 25% y/y in Q4. Although fuel costs will remain high, giving its hedging strategy, Ryanair will partly benefit from the drop of spot oil prices, thus significantly reducing the cost of the 10% of the volumes which are not hedged at $73/bbl. Fig. 13: Quarterly analysis Q4 05/09 Scheduled revenues Ancillary revenues Total sales Staff costs Fuel & oil Maintenance, materials & repairs Marketing & distribution costs Route charges Airport & handling charges Other Expenses EBITDAR Aircraft rentals Exceptional costs EBITDA Depreciation & amortisation EBIT Foreign exchange (losses) Gain on disposal of PP&E Interest income Interest expense Pre-tax profit Taxes Net income EPS – basic (€ cent) (restated) EBITDAR margin EBITDA margin EBIT margin 304.9 70.8 375.7 (46.7) (110.7) (13.0) (2.8) (39.9) (52.3) (18.5) 91.9 (16.4) (5.9) 69.6 (31.8) 37.8 (1.0) (0.1) 10.9 (18.8) 28.8 (1.1) 27.7 1.8 24.5% 18.5% 10.1% Mar-06 1,433.4 259.2 1,692.5 (171.4) (462.5) (37.4) (13.9) (164.6) (216.3) (79.6) 546.8 (47.4) 499.5 (124.4) 375.0 (1.2) 0.8 38.2 (74.0) 338.9 (32.2) 306.7 19.9 32.3% 29.5% 22.2% Q1 06/07 490.0 76.6 566.6 (56.7) (167.5) (10.7) (5.7) (48.1) (67.9) (25.4) 184.7 (12.4) 172.3 (35.6) 136.7 (0.3) 12.9 (20.6) 128.6 (12.9) 115.7 7.5 32.6% 30.4% 24.1% Q2 06/07 602.1 87.7 689.8 (57.1) (169.6) (10.6) (5.9) (50.3) (71.2) (26.9) 298.1 (13.0) 285.1 (36.0) 249.1 (0.9) 16.1 (20.7) 243.6 (30.1) 213.4 13.8 43.2% 41.3% 36.1% Q3 06/07 397.6 95.2 492.8 (56.9) (174.9) (10.8) (4.2) (47.7) (65.6) (23.3) 109.3 (15.5) 93.8 (36.6) 57.2 (0.0) 14.9 (20.8) 51.2 (3.5) 47.7 3.1 22.2% 19.0% 11.6% Q4 06/07 359.3 84.5 443.8 (51.2) (155.3) (11.1) (2.2) (46.6) (59.0) (22.2) 96.2 (22.2) 74.0 (35.5) 38.5 0.0 12.0 (22.0) 28.5 (4.3) 24.2 1.6 21.7% 16.7% 8.7% Mar-07e 1,849.0 344.0 2,193.0 (221.9) (667.3) (43.3) (18.1) (192.7) (263.7) (97.8) 688.3 (63.0) 625.2 (143.7) 481.5 (1.3) 55.8 (84.1) 451.9 (50.8) 401.1 26.0 31.4% 28.5% 22.0% 06 vs. 07e 29.0% 32.7% 29.6% 29.4% 44.3% 15.6% 29.9% 17.1% 21.9% 22.9% 25.9% 33.1% 25.2% 15.5% 28.4% 2.8% -100.0% 45.9% 13.7% 33.3% 57.9% 30.8% 30.8% Source: Ryanair quarterly reports and Bryan Garnier & Company estimates 25 Ryanair Holdings 8. Financial overview The consolidated financial statements of Ryanair Holdings presented below, are prepared in accordance with the International Financial Reporting Standards (IFRS), as adopted by the European Union. 8.1. Per share data Fig. 14: Per share data (€) (€) Averg. n° of shares - basic (k) Averg. n° of shares - diluted (k) Basic EPS (€ cent) EPS growth (restated) CFPS (€ cent) Mar-02 728,726 739,961 20.6 43.9% 37.3 Mar-03 755,055 766,279 31.7 59.2% 21.9 Mar-04 757,447 765,131 27.3 -13.7% 26.2 Mar-05 759,911 764,003 36.8 35.5% 45.9 Mar-06 Mar-07e Mar-08e Mar-09e Mar-10e Mar-11e 766,833 1,545,490 1,545,490 1,545,490 1,545,490 1,545,490 771,781 1,559,984 1,559,984 1,559,984 1,559,984 1,559,984 40.0 9.5% 47.8 26.0 30.8% 21.8 31.1 19.8% 25.5 39.5 27.1% 36.2 46.9 18.8% 44.5 54.4 16.0% 52.2 Source: Ryanair and Bryan Garnier & Company estimates 8.2. Enterprise value Fig. 15: Enterprise value (€m) (€m) Market cap. + cash - debt Enterprise value (EV) Mar-02 4,811.0 893.8 550.5 4,467.8 Mar-03 4,681.3 1,058.9 827.4 4,449.9 Mar-04 3,469.1 1,257.0 953.0 3,165.1 Mar-05 4,589.9 1,605.7 1,414.9 4,399.0 Mar-06 6,004.3 1,972.0 1,677.7 5,710.1 Mar-07e 9,010.2 2,308.5 2,155.3 8,857.0 Mar-08e 9,010.2 2,702.7 2,475.5 8,783.0 Mar-09e 9,010.2 3,262.7 2,755.4 8,502.9 Mar-10e 9,010.2 3,950.5 3,021.0 8,080.7 Mar-11e 9,010.2 4,757.8 3,287.3 7,539.7 Source: Bryan Garnier & Company estimates 8.3. Stock market ratios Fig. 16: Stock market ratios (€m) P/E (x) P/CF (x) Dividend yield EV/Sales EV/EBITDAR EV/EBITDA EV/EBIT Mar-02 32.0 17.7 n/a 7.2 19.8 20.1 27.4 Mar-03 19.6 28.3 n/a 5.3 13.1 13.1 16.9 Mar-04 16.8 17.5 n/a 2.9 8.3 9.0 12.7 Mar-05 16.4 13.2 n/a 3.3 9.3 9.8 12.9 Mar-06 19.6 16.4 n/a 3.4 10.4 11.4 15.2 Mar-07e 22.5 26.8 n/a 4.0 12.9 14.2 18.4 Mar-08e 18.8 22.9 n/a 3.5 10.1 11.0 14.4 Mar-09e 14.8 16.1 n/a 2.9 8.0 8.7 11.2 Mar-10e 12.4 13.1 n/a 2.4 6.6 7.1 9.1 Mar-11e 10.7 11.2 n/a 1.9 5.4 5.8 7.4 Source: Ryanair and Bryan Garnier & Company estimates 26 Ryanair Holdings 8.4. Profit & Loss Account Fig. 17: P&L statement, 2002-11e (€m) Scheduled revenues Ancillary revenues Total sales Staff costs Fuel & oil Maintenance, materials & repairs Marketing & distribution costs Route charges Airport & handling charges Other Expenses EBITDAR Aircraft rentals Exceptional costs EBITDA Depreciation & Amortisation EBIT Interest income Interest expense Other Pre-tax profit Taxes Net income Financial ratios Sales growth EBITDAR margin EBITDA margin EBIT margin ROA ROE ROI ROCE Gearing 28.0% 36.2% 35.6% 26.1% 9.5% 18.0% 9.7% 20.1% -34.2% 35.0% 40.4% 40.4% 31.3% 11.0% 21.3% 11.6% 22.1% -18.6% 27.5% 35.4% 32.8% 23.2% 7.6% 15.3% 8.6% 18.1% -20.9% 22.8% 35.8% 34.2% 25.8% 8.3% 17.6% 8.9% 18.6% -11.0% 28.3% 32.3% 29.5% 22.2% 7.3% 16.5% 8.4% 18.4% -14.8% 29.6% 31.4% 28.5% 22.0% 7.7% 18.3% 8.8% 17.6% -6.4% 15.6% 34.4% 31.5% 24.0% 7.8% 18.2% 9.0% 19.1% -7.9% 17.1% 35.8% 32.9% 25.6% 8.5% 19.2% 9.8% 21.3% -14.6% 15.0% 36.1% 33.2% 26.1% 8.8% 18.9% 10.0% 22.7% -22.1% 13.6% 36.1% 33.3% 26.3% 8.9% 18.2% 10.1% 23.8% -29.1% Mar-02 551.0 73.1 624.1 (78.2) (103.9) (26.4) (12.4) (46.7) (84.9) (45.6) 226.0 (4.0) 221.9 (59.0) 162.9 27.5 (19.6) 1.5 172.4 (22.0) 150.4 Mar-03 732.0 110.6 842.5 (93.1) (128.8) (29.7) (14.6) (68.4) (108.0) (59.5) 340.3 340.3 (76.9) 263.5 31.4 (30.9) 0.6 264.6 (25.2) 239.4 Mar-04 924.6 149.7 1,074.2 (123.6) (175.0) (43.4) (16.1) (110.3) (147.2) (78.0) 380.5 (11.5) (16.3) 352.7 (103.7) 248.9 23.9 (47.6) 3.2 228.5 (21.9) 206.6 Mar-05 1,128.1 190.9 1,319.0 (141.7) (265.3) (26.3) (19.6) (135.7) (178.4) (79.5) 472.6 (21.5) 451.1 (110.4) 340.7 28.3 (57.6) (2.3) 309.2 (29.2) 280.0 Mar-06 1,433.4 259.2 1,692.5 (171.4) (462.5) (37.4) (13.9) (164.6) (216.3) (79.6) 546.8 (47.4) 499.5 (124.4) 375.0 38.2 (74.0) (0.4) 338.9 (32.2) 306.7 625.2 (143.7) 481.5 55.8 (84.1) (1.3) 451.9 (50.8) 401.1 797.9 (188.7) 609.2 62.6 (122.7) 549.2 (68.6) 480.5 977.1 (215.3) 761.9 74.6 (138.6) 697.8 (87.2) 610.6 1,134.1 (242.0) 892.0 90.2 (153.1) 829.1 (103.6) 725.5 1,290.1 (270.4) 1,019.7 108.9 (167.2) 961.4 (120.2) 841.2 Mar-07e 1,849.0 344.0 2,193.0 (221.9) (667.3) (43.3) (18.1) (192.7) (263.7) (97.8) 688.3 (63.0) Mar-08e 2,135.0 401.1 2,536.1 (256.6) (694.5) (50.0) (20.9) (222.9) (305.0) (113.2) 873.1 (75.2) Mar-09e 2,497.2 473.8 2,971.0 (300.6) (772.9) (58.6) (24.5) (261.1) (357.3) (132.6) 1,063.5 (86.4) Mar-10e 2,866.4 549.3 3,415.7 (345.6) (879.7) (67.4) (28.2) (300.1) (410.7) (152.4) 1,231.6 (97.5) Mar-11e 3,250.4 629.0 3,879.4 (392.5) (999.1) (76.5) (32.0) (340.9) (466.5) (173.1) 1,398.8 (108.7) Source: Ryanair and Bryan Garnier & Company estimates 27 Ryanair Holdings 8.5. Balance Sheet Fig. 18: Balance sheet, 2002-11e (€m) Cash & marketable securities Derivative financial instruments Receivables Inventories Other current assets Current Assets Net fixed assets Intangibles Derivative financial instruments Total assets Trade payables Accrued exp. and other liabilities Current maturities of long term debt Derivative financial instruments Current tax Current Liabilities Provisions Derivative financial instruments Deferred income tax liability Other creditors Long term debt Long Term Liabilities Issued share capital Share premium account Retained Earnings Other reserves Profit/Loss for the year Total Liab. & Shareholder Equity Mar-02 893.8 10.3 17.1 11.0 932.3 951.8 1,884.1 46.8 210.5 38.8 6.6 302.7 49.3 18.1 511.7 579.1 9.6 553.5 288.9 150.4 1,884.1 Mar-03 1,058.9 15.0 22.8 16.4 1,113.0 1,352.4 2,465.4 61.6 251.3 53.5 9.8 376.2 67.8 5.7 773.9 847.4 9.6 553.5 439.2 239.4 2,465.4 Mar-04 1,257.0 14.9 26.4 19.3 1,317.6 1,576.5 44.5 2,938.7 67.9 328.4 80.3 9.8 486.5 6.5 87.7 30.0 872.6 996.9 9.6 560.4 678.6 206.6 2,938.7 Mar-05 1,605.7 20.6 2.5 24.6 1,653.4 2,117.9 46.8 3,818.1 92.1 418.7 121.0 17.5 649.3 7.2 104.2 29.1 1,293.9 1,434.3 9.7 565.8 878.6 0.5 280.0 3,818.2 Mar-06 1,972.0 18.9 29.9 3.4 29.5 2,053.6 2,533.0 46.8 0.8 4,634.2 79.3 570.6 153.3 27.4 15.2 845.9 16.7 81.9 127.3 46.1 1,524.4 1,796.4 9.8 596.2 1,160.9 (81.7) 306.7 4,634.2 Mar-07e 2,308.5 18.9 39.6 4.0 31.4 2,402.4 3,290.5 46.8 0.8 5,740.5 104.0 751.7 159.2 27.4 18.5 1,060.8 21.7 81.9 127.3 59.7 1,996.1 2,286.6 9.8 596.2 1,467.6 (81.7) 401.1 5,740.5 Mar-08e 2,702.7 18.9 45.8 4.6 36.3 2,808.3 3,786.8 46.8 0.8 6,642.7 114.0 827.5 199.6 27.4 21.3 1,189.9 25.1 81.9 127.3 69.0 2,275.9 2,579.2 9.8 596.2 1,868.7 (81.7) 480.5 6,642.7 Mar-09e 3,262.7 18.9 53.6 5.4 42.5 3,383.0 4,256.5 46.8 0.8 7,687.1 130.1 945.7 227.6 27.4 25.0 1,355.8 29.4 81.9 127.3 80.9 2,527.8 2,847.2 9.8 596.2 2,349.2 (81.7) 610.6 7,687.1 Mar-10e 3,950.5 18.9 61.7 6.2 48.7 4,086.0 4,719.0 46.8 0.8 8,852.5 148.6 1,081.3 252.8 27.4 28.7 1,538.8 33.7 81.9 127.3 93.0 2,768.2 3,104.1 9.8 596.2 2,959.8 (81.7) 725.5 8,852.5 Mar-11e 4,757.8 18.9 70.0 7.0 55.3 4,909.0 5,190.2 46.8 0.8 10,146.8 168.6 1,226.9 276.8 27.4 32.5 1,732.3 38.3 81.9 127.3 105.6 3,010.5 3,363.6 9.8 596.2 3,685.3 (81.7) 841.2 10,146.8 Source: Ryanair and Bryan Garnier & Company estimates 28 Ryanair Holdings 8.6. Cash Flow Fig. 19: Cash flow statement, 2002-11e (€m) Net income before tax (+) Depreciation & amortisation (+/-) Change in provisions (+) Share based payments (-) Deferred Tax Asset/Liability (Gain) on disposal of fixed assets (-) Tax paid (+/-) Change in Working Capital CF operating activities (-) Capex - Aircrafts (-) Capex - other tangible assets (-) Capex - Tangible assets (-) Acquisitions (+) Proceeds from sale of PP&E (+) Change in derivative financial instruments (net) CF from investing activities (+/-) Net proceeds from shares issued (+/-) Change in financial debt CF from financing activities Effect of foreign ex.e rate changes Reserve IFRS translation Other Change in Cash and equivalents 182.0 147.8 329.8 0.5 272.1 0.1 276.9 277.0 (7.6) 165.1 6.9 125.5 132.5 (5.8) 198.1 5.4 461.9 467.3 (6.4) (24.6) 348.7 30.6 262.9 293.5 (0.3) (82.1) (2.3) 366.3 477.6 477.6 336.5 320.3 320.3 394.2 279.9 279.9 560.0 265.6 265.6 687.8 266.3 266.3 807.3 (397.2) (469.9) (364.3) (629.8) 90.4 (447.3) (901.3) (685.0) (685.0) (704.5) (741.6) Mar-02 172.4 59.0 19.2 (0.5) (22.0) 111.0 339.0 (394.8) (2.4) (397.2) Mar-03 264.6 76.9 18.5 (25.2) 30.8 365.6 (474.8) 4.9 (469.9) Mar-04 228.5 101.4 (61.3) 87.7 (21.9) 101.3 435.7 (317.7) (13.9) (331.6) (32.7) Mar-05 309.2 110.4 0.7 0.5 16.5 (29.2) 134.1 542.2 (627.2) (4.8) (632.0) 2.2 Mar-06 338.9 124.4 9.5 2.9 23.1 (0.8) (32.2) 138.8 604.6 (542.5) (3.7) (546.2) 8.5 Mar-07e 451.9 143.7 4.9 (50.8) 210.5 760.2 (875.0) (26.3) (901.3) Mar-08e 549.2 188.7 3.4 (68.6) 86.4 758.9 (665.0) (20.0) (685.0) Mar-09e 697.8 215.3 4.3 (87.2) 134.9 965.1 (665.0) (20.0) (685.0) Mar-10e 829.1 242.0 4.4 (103.6) 154.9 1,126.8 (684.0) (20.5) (704.5) Mar-11e 961.4 270.4 4.6 (120.2) 166.3 1,282.5 (720.0) (21.6) (741.6) - Source: Ryanair and Bryan Garnier & Company estimates 29 easyJet plc Low-cost, but with emphasis on care & convenience Target price 842p / Current price 684p Airlines Bloomberg Reuters High / Low (£p) Market Cap (£ m) EV (2007 BG Estimate) (£ m) Volume 6m Avge (in '000 Shares) Free float EPS growth 06 -09e Gearing 2006 Dividend yield YE: 31 March Sales (£ m) % change yoy EBIT (£ m) EBIT margin EPS (pence) EV / Sales EV / EBIT P/E (x) PEG ratio 2005 1,341.4 23% 66.2 4.9% 14.8 0.5 10.7 19.8 0.5 2006 1,619.7 21% 117.8 7.3% 23.2 1.0 13.4 21.0 0.4 2007e 2,004.0 24% 182.7 9.1% 28.9 1.3 14.2 23.7 0.1 EZJ LN EZJ.L 730 / 302 2,862.6 2,590.9 2,918.2 60.0% 31.1% -40.1% n/a 2008e 2,255.2 13% 252.7 11.2% 39.5 1.1 10.2 17.3 0.5 9th March 2007 Buy We initiate coverage of easyJet, the second largest European lowcost airline, with a BUY and a target price of 842p representing 23% upside. Based on the renewal and development of its fleet, together with the reinforcement of its presence in key markets, we expect easyJet to improve both its top-line and operating margins, deriving an EPS CAGR in the area of 30% over 2006/2010. With its solid market presence and scale, easyJet is well positioned to take advantage of growth opportunities in the European low-cost segment. easyJet has 6% of the total European market, which is forecast to grow by 5-6% per annum. On this basis, we have targeted a seat capacity growth rate of 15% p.a. over the medium term. easyJet benefits from its brand strength across Europe, standing out from the crowd in terms of peer recognition and universal acclaim. For the latest quarter (Nov 06 – Jan 07) easyJet was ranked 5th in the IMRGHitwise Hot Shops List of the top 50 UK e-retailers, making it the highest ranked travel website and airline. easyJet opened its 17th base in Europe and its 1st in Spain on 16th February 2007, with a network of 18 routes from Madrid, significantly enlarging its addressable market. Whilst passenger volumes are set to soar as new aircraft are delivered, we see easyJet focusing its growth on increased frequencies to existing destinations in FY 07. In this way, rising asset utilisation will continue to enhance profitability. Our analysis concludes easyJet will outperform peers on superior revenue growth and profitability. Strong Buy, target price 842p. 360 340 320 300 280 260 240 220 200 1 80 1 60 1 40 1 20 1 00 80 Jan- M ar- M ay- Jul- Sep- No v- Jan- M ar- M ay- Jul- Sep- No v- Jan05 05 05 05 05 05 06 06 06 06 06 06 07 EZJ-LN DJS TM A irlin DJ EURO STOXX50 Alexandre Boukhari: +33 1 56 68 75 01 aboukhari@bryangarnier.fr easyJet plc 2004A Revenue / E B I T DA R M ar gi n 25. 0% 25. 0% 2005A 23.0% 15.4% 31.1% 87.0 0.5 2006A 20.7% 17.2% 77.9% (89.1) 0.4 2007E 23.7% 17.7% 55.1% (122.8) 1.0 2008E 12.5% 19.4% 38.3% 9.1 0.5 2009E 15.5% 21.0% 34.2% (99.1) 0.4 2010E 15.1% 21.9% 28.5% 166.4 0.4 20. 0% 20. 0% 15. 0% 15. 0% Growth Credentials Revenue growth EBITDAR margin EBIT growth Free cash flow PEG ratio Income statement (key data) Scheduled revenues Ancillary revenues Airport charges Fuel EBITDAR EBITDA EBIT Net interest Tax Net income EPS (pence) Cash Flow Earnings before interest and taxes Depreciation & amortisation Change in WCR Other Cash flow from operations Capex Cash flow from investing activities Change in financial debt Dividends Other Net cash flow CFPS (pence) Balance Sheet Tangible fixed assets Goodwill & other assets Trade debtors Other current assets Cash and equivalent Total Assets L-T debt Other non current liabilities S-T debt Trade payables & accrued expenses Other current liabilities Shareholders equity Total liabilities & shareholders equity Ratios ROCE ROE ROA Gearing Interest cover Cap ex/depreciation P/BV EV / EBITDA EV / EBIT 17.1% 17.4% -10.3% 103.6 0.5 10. 0% 10. 0% 5. 0% 5. 0% 0. 0% 2004A 2005A 2006A 2007E 2008E 2009E 2010E Revenue gr owt h E B I T DA R mar gi n 0. 0% E B I T gr owt h / E P S 90. 0% 80. 0% 70 70. 0% 60. 0% 50. 0% 40. 0% 40 30. 0% 20. 0% 10. 0% 0. 0% 10 -10. 0% -20. 0% 2004A 2005A 2006A 2007E 2008E 2009E 2010E E P S (pence) E B I T gr owt h 0 30 20 60 50 80 1,029.3 61.7 (191.4) (146.9) 189.3 92.9 50.5 11.5 (21.1) 41.1 10.3 1,254.2 87.2 (230.1) (260.2) 206.5 82.8 66.2 16.3 (23.6) 59.0 14.8 1,488.4 131.3 (258.4) (387.8) 278.5 146.0 117.8 11.3 (35.1) 94.1 23.2 1,812.1 191.8 (316.5) (479.8) 354.7 225.9 182.7 (12.6) (49.3) 120.8 28.9 2,001.0 254.2 (352.6) (513.0) 437.4 306.8 252.7 (20.1) (67.4) 165.1 39.5 2,259.9 344.5 (403.2) (562.8) 547.4 408.3 339.0 (31.3) (89.2) 218.5 52.2 2,567.8 430.6 (459.5) (634.9) 657.5 504.3 435.7 (39.5) (114.9) 281.3 67.2 Company description Having begun operations in March 1995, the principal activity of easyJet is to provide a "low-cost, good-value" airline service for short and mediumhaul point-to-point routes across Europe. easyJet keeps costs low by eliminating unnecessary costs and 'frills' which characterise 'traditional' airlines. The airline is head-quartered at easyLand, a bright orange building adjacent to the main taxiway at Luton Airport. easyJet currently has operating bases throughout the UK and mainland Europe. It is a truly European operation, and was one of the few airlines to take advantage of the reforms offered by the single European aviation market. easyJet was listed on the London Stock Exchange on 15th November 2000. easyJet was listed on the London Stock Exchange on 15th November 2000. 50.5 42.4 64.2 5.0 162.1 (61.9) (58.5) 66.5 0.0 4.8 174.9 44.0 66.2 16.6 104.0 62.9 249.7 (237.0) (162.7) 99.3 0.0 (23.5) 162.8 40.8 117.8 28.2 77.9 1.3 225.2 (408.3) (314.3) 278.4 0.0 11.5 200.8 49.5 182.7 43.2 47.8 (44.5) 229.1 (351.9) (351.9) 111.2 0.0 0.0 (11.6) (2.8) 252.7 54.2 52.9 (76.2) 283.6 (274.5) (274.5) 204.2 0.0 0.0 213.3 51.0 339.0 69.2 71.2 (104.7) 374.7 (473.8) (473.8) 309.6 0.0 0.0 210.5 50.3 435.7 68.5 84.3 (136.6) 452.0 (285.6) (285.6) 153.6 0.0 0.0 320.0 76.5 330.4 309.8 99.2 75.2 510.3 1,324.9 110.1 110.7 9.7 144.0 161.0 789.4 1,324.9 405.7 340.3 103.7 107.0 673.1 1,629.8 201.0 150.9 16.3 162.0 219.8 863.4 1,613.4 695.7 340.7 128.0 85.3 873.9 2,123.6 446.9 184.8 32.8 217.6 258.6 982.9 2,123.6 1,004.4 340.7 167.0 120.2 862.3 2,494.6 556.4 219.9 34.5 262.5 317.6 1,103.7 2,494.6 1,224.7 340.7 187.9 135.3 1,075.6 2,964.2 730.1 242.9 64.9 287.7 369.8 1,268.8 2,964.2 1,629.2 340.7 217.0 156.3 1,286.2 3,629.4 1,009.9 274.8 94.8 324.3 438.4 1,487.3 3,629.4 1,846.3 340.7 249.9 179.9 1,606.1 4,222.8 1,116.7 310.8 141.6 368.3 516.9 1,768.6 4,222.8 7.2% 5.3% 3.4% -49.5% (4.4) 1.5 64.0 1.2 2.3 10.1% 7.1% 4.0% -52.8% (4.1) 14.3 135.0 8.6 10.7 12.5% 10.2% 5.0% -40.1% (10.4) 14.9 200.6 10.8 13.4 13.7% 11.6% 5.2% -24.6% 14.5 8.1 259.3 11.5 14.2 16.1% 13.9% 6.0% -22.1% 12.6 5.1 225.6 8.4 10.2 16.7% 15.9% 6.6% -12.2% 10.8 6.8 192.5 6.6 7.9 19.6% 17.3% 7.2% -19.7% 11.0 4.2 161.8 5.0 5.8 31 easyJet plc 1. Investment Case What’s changed? easyJet is evolving from a classic “low-cost” model to a hybrid “good value” play. While Ryanair continues its relentless focus on the classic low-cost model, easyJet has started to add some “frills”. Essentially, it is addressing the cost-sensitive share of the business traveller market and should continue to reinforce this stance. easyJet is paving the way for doubled EBIT margins by 2010 (peaking at 15.4% in 2012) thanks to 1). increased revenues per seat, 2). a deceleration in the growth of new routes, 3). the renewal of its fleet with cost-efficient aircraft, 4). a more favourable financing strategy and 5) . major new maintenance contracts. Valuation Our target price of 843p is DCF derived, using conservative assumptions. We have developed a 10-year forecast business model, which includes a sales CAGR of 12% and a terminal value growth rate of 0.5%. We assume an average WACC of 9%, using a risk premium of 4% and a beta of 1.5. Catalysts 9th May 2007 interim results for financial period ended 31st September 2007 will give management the opportunity to outline expected gains from its current strategy. Difference from consensus The consensus is over-obsessed by high current trading multiples, the volatile oil price and potential rising costs from suppliers. The following report focuses on the ambitious, but realistic, cost reduction programme. This, combined with the beneficial impact of a change in fleet financing, will counteract rising costs and the widely anticipated dip in revenues per passenger. Our estimates for top-line growth and EBIT margin progression are more aggressive than most, justified by a strategy focused on increased profitability and disciplined capacity growth. Risks Strengthened competition - With its new base at Madrid’s Barajas airport, easyJet is expected to compete directly with low-cost rival Ryanair. At this stage however, there are few overlaps on their respective routes. Move to a hybrid model - Risk is that a gap opens at the bottom of the market for someone in Europe to come in with a pure low-cost model and increase the pressure. Environmental issues – The proposed emissions trading scheme could hit low-cost carriers harder than mainline players, effectively penalising airlines that have already upgraded their fleets (if Brussels adopts a system rewarding fleet upgrades). Unquantifiable competitive risk - Transavia (Air France-KLM low-cost airline) is expected to start operations in June 2007, offering charter and scheduled low-fare flights, based at Paris Orly South. It will operate a fleet of 186-seat 737-800s to a selection of popular tourist destinations such as Morocco, Tunisia and Spain. 32 easyJet plc 2. Valuation 2.1. Share price Fig. 20: easyJet share price performance since the January 2005 340 Ryanair share price fluctuation 290 240 190 140 90 Nov-05 Nov-06 Jan-05 Jul-05 Jan-06 Jul-06 Mar-05 May-05 Mar-06 May-06 Sep-05 Sep-06 Jan-07 EZJ-LN DJ EURO STOXX50 DJS TM Airlin Source: Thomson One Banker 2.2. Modelling and DCF valuation In building our model, we detail how revenues will develop with respect to fleet and Available Seat Kilometre (ASK) growth, load factor improvements and the expected increase in sales per passenger on the development of qualitative ancillary services. On top of this, we built a cost and capex model that puts the emphasis on cost cutting and economy of scale strategies derived from an increased fleet. Our DCF model derives a target price of 843p, indicating an upside potential of 23%. We value easyJet using conservative assumptions. We used an explicit forecast period of 10 years to September 2016 that takes the main value drivers from the detailed estimates of accounts that are presented at the end of this report. For the terminal value of £4,837m, we estimate a normalised level of the main value drivers that we consider achievable in the industry over the long-term. We draw the reader’s attention to the fact that the years 6-10 follow a linear approximation to the terminal period. The parameters used to calculate our weighted average cost of capital (WACC) are shown in Fig 21. In our approach, we used a variable WACC, as the company’s debt was minimal on 30th September 2006, but will grow significantly over the next few years, as its aircraft acquisition strategy changes. 33 easyJet plc Management expects to move from an 85% leased aircraft fleet (off balance sheet) to at least a 50% owned 50% leased scenario. The average WACC used over the period is 9.0% (taxed WACC). Our composite beta of 1.5x is computed taking into account the beta from Bloomberg (1.02x), the economic seasonality of this business, the major and uncontrollable impacts of fuel and dollar volatility. Our terminal value assumes a 0.5% FCF growth rate. We believe this to be conservative, given the expected increase in seat capacities over the period under review, and CEE growth prospects. In addition, we anticipate easyJet will be able to increase its revenue per passenger with the development of ancillary services, as customers are prepared to pay a little more for added extras An EBITDA growing at 19% p.a. over our explicit forecast period, well in excess of gross capex (9% on average), also appears conservative. We expect a significant improvement in the EBIT margin to around 13% by 2009 compared with 7.3% for 2006 and our 9.1% estimate for 2007. As competition strengthens, we do not anticipate a huge potential for price increases (rather a stagnation of the average fare excluding ancillary services over the forecast period); however we do predict significant growth in ancillary revenues as easyJet’s offering widens in optional services. Fig. 21: WACC calculation Assumptions Tax rate Risk free rate Risk premium Beta Cost of equity Cost of debt After-tax cost of debt Average WACC (cost of capital) Source: Bryan Garnier & Company estimates 29-30% 4.8% 4.0% 1.5x 10.8% 6.4% 4.5% 9.0% As the company has limited financial debt, easyJet’s cost of capital could be substantially improved. An increased leverage could therefore lead to an even higher valuation. 34 easyJet plc Fig. 22: DCF model, FY06/07e-16/17e DVF Valuation (Euro m) Sales growth EBITDA margin Capex Free cash flow WACC Cumulative WACC NPV of FCF Total NPV Add: excess cash Add: financial investments Less: debt Valuation Number of shares outstanding (k) Theoretical value per share (p) 480 3,524 419 842 06/07e 23.7% 11.3% (351.9) (131.2) 9.7% 1.10 (119.6) 3,130 874 07/08e 12.5% 13.6% (274.5) 12.0 9.4% 1.20 10.0 08/09e 15.5% 15.7% (473.8) (92.7) 9.1% 1.31 (70.7) 09/10e 15.1% 16.8% (285.6) 176.6 8.9% 1.43 123.9 10/11e 11.9% 17.6% (291.3) 226.6 8.8% 1.55 146.1 11/12e 9.0% 17.9% (297.1) 254.8 8.7% 1.69 151.1 12/13e 8.2% 17.7% (209.8) 370.8 8.7% 1.83 202.4 13/14e 8.6% 17.6% (214.0) 417.7 8.7% 1.99 209.7 14/15e 7.9% 17.5% (218.3) 455.7 8.8% 2.17 210.2 15/16e Term. Val. 7.1% 17.5% (197.9) 514.3 8.9% 2.36 217.9 0.0% 14.4% (197.9) 4,837.2 8.9% 2.36 2,048.8 Source: Bryan Garnier & Company estimates 2.3. Sensitivity The table below shows the effect of changes in the terminal FCF growth rate and beta on the target price. It illustrates that even using a more conservative terminal FCF growth rate of -0.5% and a beta of 1.8x, which implies an average WACC of 10%, we derive a fair value of 708p, clearly demonstrating today’s severe undervaluation. Fig. 23: Sensitivity of fair value (€) to terminal growth rate and beta Beta 1.20 -0.5% Terminal growth rate 0.0% 0.5% 1.0% 1.5% 890 922 958 1000 1048 1.30 854 884 917 954 997 1.40 821 848 878 912 951 1.50 790 815 842 873 908 1.60 761 783 809 837 868 1.70 734 754 777 803 832 1.80 708 727 748 771 798 Source: Bryan Garnier & Company estimates 2.4. easyJet is trading at a premium vs. peers We have cross-checked our DCF valuation approach with peer group comparisons to other LCC and flag airlines. We present the trading multiples on page 7 of this report. easyJet is trading at the upper end of its range vs. peers, with 2007 and 2008 PEs of 20x and 15x respectively. NB. Both easyJet and Ryanair (which are comparable in terms of size) are also trading on similar ratios, at significant premium to other airlines. We believe the easyJet’s trading premium is consistent given it is the undisputed LCC, generating higher operating margins than rivals, and deriving impressively large free cash flows after capex. 35 easyJet plc 3. A business model to rival low-cost and traditional carriers 3.1. A cost advantage As a rule of thumb, low-cost carriers have an overall cost advantage of some 50% relative to traditional airlines. This is achieved due to a better cost structure and relies on the following aspects in Fig. 24. Fig. 24: Low-cost Carrier Advantages Imrproved aircraft configuration Increased aircraft utilisation 3% Low er crew costs 3% Use of secondary or tertiary airports 6% Use of single aircraft type 2% Reduction in ground staff No in-flight catering No agents commission Low er selling costs 16% 84% 81% 78% 72% 70% 60% 54% 48% 45% 43% 10% 6% 6% 3% Low er administrative costs 2% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Advantage Cumultive advantage LCC Source: Europairs research (2002) Whilst easyJet mirrors traditional airlines in the sense that it operates out of primary airports, its business model is faithful to the low-cost method in all other respects: Reduced personnel costs - Unproductive personnel are kept to a minimum, ensuring a very high level of productivity, as measured by ASK or passengers per employee. Low marketing and distribution costs, achieved on high levels of internet bookings (98%). A largely uniform fleet, composed of two aircraft types (Boeing 737-700 and Airbus A319), resulting in lower maintenance costs, and greater crew and aircraft operational flexibility. No additional in-flight services included in the travel fare, airport lounges or loyalty programmes. As a result, and despite efforts realised by network airlines to reduce their own costs to compete with low-cost rivals, our analysis highlights the fact that easyJet maintains a significant cost advantage. This is underscored in the table below. 36 easyJet plc Fig. 25: Low-cost Carrier Advantages Cost per ASK 8.0 7.0 6.0 € cents 5.0 4.0 3.0 2.0 1.0 0.0 RYA EZJ SKY AF BAY 3.4 6.0 5.8 7.6 6.9 Source: Bryan Garnier & Company Over the past few years, unit costs grew for all the airlines, reflecting the huge increase in their respective oil bills. However, we expect this rate of increase to decline, and even turn negative, depending on the future oil price. 3.2. Revenue opportunities Primary airports easyJet exhibits higher unit revenues driven by a network based on primary airports and greater flight frequencies. easyJet’s average revenue per passenger amounted to €70 in 2006 vs. €50 for Ryanair (and €64 for SkyEurope). Although the use of primary airports is an expensive choice1, it nevertheless allows easyJet to attract cost-sensitive business passengers looking for: 1) departures from traditional airports, with 2) convenient time schedules and 3) lower price tickets. 20-30% of scheduled revenues are derived from business travellers. This is one of easyJet’s strengths, as the average fares paid by the business traveller are £15 higher than those paid by leisure passengers. In addition, easyJet has developed ancillary products and services designed for the business traveller who is willing to pay a premium for late reservations, specific departure dates and speedy boarding. Further scope for development of ancillary revenues easyJet’s revenue per passenger is 40% higher on average than Ryanair’s easyJet airport charges per seat amounted to €11.6 in 2006 compared to €6.2 for Ryanair, given primary airports charge three times more than secondary ones on average. 1 37 easyJet plc Thanks to the expansion and implementation of new services, ancillary revenues improved significantly in all areas, rising by 34% per seat in 2006. We expect ancillary revenues to continue to rise sharply. They represented 8% of easyJet’s total revenues for the 12-month period ended September 31st 2006 and we anticipate them to represent 13% of total revenues by September 2009. By contrast, ancillary revenues represented 15% of Ryanair total sales in 2006. This growth was achieved through the development of new services and via the leverage of easyJet’s website, which is becomes a valuable intangible asset. Fleet extension We anticipate a substantial capacity enhancement of some 15% in seat capacities p.a. from 2007 to 2009 from the enlargement of the fleet, following a contract signed end-2002 with Airbus. In light of airbus delivery schedules (85 A319s to be delivered between 2007 and 2011) and the option (on identical payment terms) to procure an additional 123 A319s from 2008 to 2015, we expect easyJet’s fleet will reach 174 aircraft by September 2009 and 230 by 2012. While increasing its growth profile, the new Airbus aircraft will allow easyJet to improve its image as a Socially Responsible Enterprise (SRE). The combination of a modern fleet, with an average age of 2.2 years, and high utilisation, means it will discharge 30% fewer emissions per passenger kilometre than traditional airlines flying similar routes. 3.3. Further margin improvements to come One of easyJet’s main cost items is airport and ground-handling expenses, given the choice of its airport network. Today, easyJet is renegotiating its airport contracts with the airports, with its negotiating power boosted in the light of historic and future market share gains. In addition, volume hikes will enable additional economies of scale. We anticipate easyJet will adopt an increase in its flight frequency strategy rather than developing new routes. This will lead to improved unit revenues and limited additional costs. Furthermore, given Ryanair is in the process of extending its network reach, easyJet’s strategy means direct competition between the two will be limited. The fleet extension will be accompanied by a new financing strategy. As of September 2006, easyJet owned one third of its aircraft, the remainder being leased (operating leases). The company is now moving towards the ownership of a larger proportion of its aircraft, with the ultimate goal of achieving a 50/50 ratio. In our model, we expect this goal will be attained by 2012. This critical change in strategy will imply chunky capex, but operating margins will be positively impacted. 38 easyJet plc 4. Outstanding brand recognition In research conducted by Mintel for Business Superbrands, easyJet was identified as a brand that stood out from the crowd, earning peer recognition and acclaim amongst a sample of 47 managing and marketing directors, and rated first in a number of categories. Interestingly, in the section regarding the Business Superbrands perceived to have a European outlook, easyJet was rated number one above Nokia, Siemens, CAP Gemini and Avis. The airline also ranked as the top Business Superbrand perceived to be dynamic, creative and imaginative in securing new markets, ahead of companies such as Microsoft, Sony, Nokia and Psion. easyJet was also the company perceived to be most successful in utilising the benefits of ecommerce in serving customers above Microsoft, Federal Express, BT and HSBC. This reflects the fact that 78% of initial bookings are now made over the Internet. easyJet was ranked in the top five Business Superbrands perceived to be developing, as well as creatively managing, successful brand assets, amongst the "top five Business Superbrands respondents would most like to manage" category. A Business Superbrand is one that has established the finest reputation in its field. It offers customers significant emotional and/or tangible advantages over its competitors which (consciously or subconsciously) customers want, recognise and are confident about investing in. Business Superbrand status is awarded by the Business Superbrands Council, which is made up of eminent figures from the world of branding with particular emphasis on business. Fig. 26: easyLand HQ in Luton 39 easyJet plc 5. Financial overview The consolidated financial statements of easyJet plc presented hereafter are prepared in accordance with the International Financial Reporting Standards (IFRS), as adopted by the European Union. 5.1. Per share data Fig. 27: Per share data (£) (€) Averg. n° of shares - basic (m) Averg. n° of shares - diluted (m) Basic EPS (£ pence) EPS growth CFPS Sep-04 397.7 406.4 10.3 25.5% 44.0 Sep-05 399.3 408.9 14.8 43.0% 40.8 Sep-06 405.7 415.4 23.2 57.0% 49.5 Sep-07e 418.5 418.5 28.9 24.4% -2.8 Sep-08e 418.5 418.5 39.5 36.7% 51.0 Sep-09e 418.5 418.5 52.2 32.4% 50.3 Sep-10e 418.5 418.5 67.2 28.8% 76.5 Sep-11e 418.5 418.5 80.2 19.3% 77.9 Sep-12e 418.5 418.5 88.1 9.9% 78.7 Sep-13e 418.5 418.5 96.0 9.0% 81.7 Source: easyJet and Bryan Garnier & Company estimates 5.2. Enterprise value Fig. 28: Enterprise value (£m) (€m) Market cap. + cash - debt Enterprise value (EV) Sep-04 505.1 510.3 119.8 114.6 Sep-05 1,166.0 673.1 217.3 710.2 Sep-06 1,971.7 873.9 479.7 1,577.5 Sep-07e 2,862.3 862.3 590.9 2,590.9 Sep-08e 2,862.3 1,075.6 795.1 2,581.8 Sep-09e 2,862.3 1,286.2 1,104.7 2,680.9 Sep-10e 2,862.3 1,606.1 1,258.2 2,514.4 Sep-11e 2,862.3 1,932.3 1,369.9 2,299.9 Sep-12e 2,862.3 2,261.5 1,457.3 2,058.2 Sep-13e 2,862.3 2,603.3 1,437.2 1,696.2 Source: Bryan Garnier & Company estimates 5.3. Stock market ratios Fig. 29: Stock market ratios (£m) P/E (x) P/CF (x) Dividend yield EV/Sales EV/EBITDAR EV/EBITDA EV/EBIT Sep-04 12.3 2.9 n.a. 0.1 0.6 1.2 2.3 Sep-05 19.8 7.2 n.a. 0.5 3.4 8.6 10.7 Sep-06 21.0 9.8 n.a. 1.0 5.7 10.8 13.4 Sep-07e 23.7 -247.6 n.a. 1.3 7.3 11.5 14.2 Sep-08e 17.3 13.4 n.a. 1.1 5.9 8.4 10.2 Sep-09e 13.1 13.6 n.a. 1.0 4.9 6.6 7.9 Sep-10e 10.2 8.9 n.a. 0.8 3.8 5.0 5.8 Sep-11e 8.5 8.8 n.a. 0.7 3.0 3.9 4.5 Sep-12e 7.8 8.7 n.a. 0.6 2.5 3.1 3.6 Sep-13e 7.1 8.4 n.a. 0.4 1.9 2.4 2.8 Source: easyJet and Bryan Garnier & Company estimates 40 easyJet plc 5.4. Profit & Loss Account Fig. 30: P&L statement, 2004-13e (£m) Scheduled revenues Ancillary revenues Total sales Ground handling, incl. salaries Airport charges Fuel Navigation charges Crew cost, including training Maintenance Advertising Merchant fees and incentive pay Aircraft and passenger insurance Other costs EBITDAR Aircraft dry lease costs Aircraft long-term wet lease costs EBITDA Depreciation Amortization EBIT Interest income Interest expense Other Pre-tax profit Taxes Net income Financial ratios Sales growth EBITDAR margin EBITDA margin EBIT margin ROA ROE ROI ROCE Gearing 17.1% 17.4% 8.5% 4.6% 3.4% 5.3% 4.5% 7.2% -49.5% 23.0% 15.4% 6.2% 4.9% 4.0% 7.1% 5.5% 10.1% -52.8% 20.7% 17.2% 9.0% 7.3% 5.0% 10.2% 6.4% 12.5% -40.1% 23.7% 17.7% 11.3% 9.1% 5.2% 11.6% 7.1% 13.7% -24.6% 12.5% 19.4% 13.6% 11.2% 6.0% 13.9% 8.0% 16.1% -22.1% 15.5% 21.0% 15.7% 13.0% 6.6% 15.9% 8.4% 16.7% -12.2% 15.1% 21.9% 16.8% 14.5% 7.2% 17.3% 9.3% 19.6% -19.7% 11.9% 22.6% 17.6% 15.3% 7.4% 17.3% 9.7% 21.2% -26.7% 9.0% 22.6% 17.9% 15.4% 7.2% 16.1% 9.4% 21.3% -32.5% 8.2% 22.6% 17.7% 15.3% 7.1% 15.0% 9.3% 22.2% -40.6% Sep-04 1,029.3 61.7 1,091.0 (111.3) (191.4) (146.9) (87.7) (126.8) (102.0) (30.5) (13.6) (19.8) (71.7) 189.3 (96.4) 0.0 92.9 (25.3) (17.1) 50.5 14.2 (2.7) 0.2 62.2 (21.1) 41.1 Sep-05 1,254.2 87.2 1,341.4 (130.5) (230.1) (260.2) (108.6) (136.2) (119.2) (32.8) (15.6) (19.3) (82.4) 206.5 (123.7) 0.0 82.8 (15.8) (0.8) 66.2 27.2 (10.9) 0.1 82.6 (23.6) 59.0 Sep-06 1,488.4 131.3 1,619.7 (144.1) (258.4) (387.8) (121.2) (160.0) (109.5) (38.2) (17.9) (15.8) (88.3) 278.5 (122.9) (9.6) 146.0 (27.4) (0.8) 117.8 35.4 (24.1) 0.1 129.2 (35.1) 94.1 Sep-07e 1,812.1 191.8 2,004.0 (176.5) (316.5) (479.8) (150.0) (198.0) (131.4) (47.3) (22.1) (19.5) (108.2) 354.7 (119.7) (9.1) 225.9 (43.2) 182.7 21.7 (34.3) 170.1 (49.3) 120.8 Sep-08e 2,001.0 254.2 2,255.2 (196.6) (352.6) (513.0) (168.8) (222.8) (143.5) (53.2) (24.9) (22.0) (120.5) 437.4 (120.5) (10.0) 306.8 (54.2) 252.7 24.2 (44.4) 232.5 (67.4) 165.1 Sep-09e 2,259.9 344.5 2,604.4 (224.8) (403.2) (562.8) (194.9) (257.3) (160.7) (61.4) (28.8) (25.4) (137.8) 547.4 (127.9) (11.3) 408.3 (69.2) 339.0 29.5 (60.8) 307.8 (89.2) 218.5 Sep-10e 2,567.8 430.6 2,998.3 (256.2) (459.5) (634.9) (224.4) (296.2) (179.5) (70.7) (33.1) (29.2) (157.0) 657.5 (140.5) (12.8) 504.3 (68.5) 435.7 36.2 (75.6) 396.3 (114.9) 281.3 Sep-11e 2,833.6 522.7 3,356.3 (284.0) (509.2) (703.6) (251.1) (331.5) (194.8) (79.2) (37.1) (32.7) (174.0) 759.0 (153.5) (14.2) 591.3 (78.6) 512.7 44.2 (84.1) 472.8 (137.1) 335.7 Sep-12e 3,064.5 593.5 3,658.0 (309.5) (555.0) (766.9) (273.7) (361.4) (212.4) (86.3) (40.4) (35.7) (189.6) 827.2 (158.3) (15.3) 653.6 (88.7) 564.9 52.4 (90.5) 526.8 (158.1) 368.8 Sep-13e 3,288.4 668.7 3,957.1 (334.8) (600.4) (829.6) (296.1) (390.9) (229.7) (93.3) (43.7) (38.6) (205.2) 894.8 (177.4) (16.4) 700.9 (94.9) 606.0 60.8 (92.6) 574.2 (172.3) 401.9 Source: easyJet and Bryan Garnier & Company estimates 41 easyJet plc 5.5. Balance Sheet Fig. 31: Balance sheet, 2004-13e (£m) Cash & marketable securities Trade receivables Other current assets Current Assets Net fixed and intangible assets Goodwill Intangible assets Financial instruments Deferred Tax assets Total assets Trade payables Accrued exp. and other liabilities Unearned rev. and other payables Current maturities of long term debt Derivative financial instruments Current tax Current Liabilities Provisions Derivative financial instruments Deferred income tax liability Other creditors Long term debt Long Term Liabilities Issued share capital Share premium account Retained Earnings Other reserves Profit/Loss for the year Total Liab. & Shareholder Equity Sep-04 510.3 99.2 75.2 684.7 330.4 309.6 0.2 1,324.9 17.6 126.4 143.0 9.7 18.0 314.7 42.9 20.2 47.6 110.1 220.8 99.8 554.2 94.3 41.1 1,324.9 Sep-05 673.1 103.7 107.0 883.8 405.7 309.6 1.4 29.3 1,629.8 6.6 155.4 180.9 16.3 38.9 398.1 70.0 22.2 75.1 201.0 368.3 100.1 557.2 147.0 0.1 59.0 1,629.8 Sep-06 873.9 128.0 85.3 1,087.2 695.7 309.6 1.1 29.7 0.3 2,123.6 31.5 186.1 196.5 32.8 15.3 46.8 509.0 73.2 4.8 32.0 74.8 446.9 631.7 102.6 591.4 204.3 -9.5 94.1 2,123.6 Sep-07e 862.3 167.0 120.2 1,149.6 1,004.4 309.6 1.1 29.7 0.3 2,494.6 38.0 224.5 243.1 34.5 15.3 59.2 614.7 90.6 4.8 32.0 92.5 556.4 776.3 102.6 591.4 298.4 (9.5) 120.8 2,494.6 Sep-08e 1,075.6 187.9 135.3 1,398.9 1,224.7 309.6 1.1 29.7 0.3 2,964.2 41.6 246.0 273.6 64.9 15.3 80.9 722.4 101.9 4.8 32.0 104.1 730.1 973.0 102.6 591.4 419.2 (9.5) 165.1 2,964.2 Sep-09e 1,286.2 217.0 156.3 1,659.5 1,629.2 309.6 1.1 29.7 0.3 3,629.4 46.9 277.3 316.0 94.8 15.3 107.1 857.4 117.7 4.8 32.0 120.3 1,009.9 1,284.7 102.6 591.4 584.3 (9.5) 218.5 3,629.4 Sep-10e 1,606.1 249.9 179.9 2,035.9 1,846.3 309.6 1.1 29.7 0.3 4,222.8 53.3 315.0 363.8 141.6 15.3 137.9 1,026.8 135.5 4.8 32.0 138.5 1,116.7 1,427.4 102.6 591.4 802.8 (9.5) 281.3 4,222.8 Sep-11e 1,932.3 279.7 201.4 2,413.4 2,058.9 309.6 1.1 29.7 0.3 4,813.0 59.1 349.2 407.2 171.0 15.3 164.5 1,166.2 151.7 4.8 32.0 155.0 1,199.0 1,542.5 102.6 591.4 1,084.1 (9.5) 335.7 4,813.0 Sep-12e 2,261.5 304.8 219.5 2,786 2,267.4 309.6 1.1 29.7 0.3 5,394 64.2 379.4 443.8 202.6 15.3 189.7 1,295.0 165.3 4.8 32.0 168.9 1,254.7 1,625.8 102.6 591.4 1,419.8 (9.5) 368.8 5,393.9 Sep-13e 2,603.3 329.8 237.4 3,171 2,382.2 309.6 1.1 29.7 0.3 5,893 69.6 411.2 480.1 234.9 15.3 206.7 1,417.8 178.8 4.8 32.0 182.7 1,202.2 1,600.6 102.6 591.4 1,788.6 (9.5) 401.9 5,893.5 Source: easyJet and Bryan Garnier & Company estimates 42 easyJet plc 5.6. Cash Flow Fig. 32: Cash flow statement, 2004-13e (£m) EBIT (+) Depreciation & amortisation (+) Financial income (-) Financial interests paid (+/-) change in provisions (+/-) Other (-) Tax charge (+/-) change in trade receivables (+/-) change in other current assets (+/-) change in accounts payable (+/-) change in accrued exp. & other liabilities (+/-) change current tax (+/-) change in other creditors CF from operating activities (-) Capital expenditures - Aircrafts (-) Capex - other tangible assets (-) Capex - Tangible assets (-) Acquisitions (+) Proceeds from sale of PPE CF from investing activities Net proceeds from shares issued (+/-) Change in financial debt (+/-) Change in derivative fin. Inst. CF from financing activities Other Change in Cash and equivalents (58.5) 66.5 4.8 71.3 174.9 (61.9) 3.4 12.4 4.2 85.6 162.1 27.4 249.7 (162.3) (74.7) (237.0) (1.4) 75.7 (162.7) 2.0 99.3 (14.2) 87.1 (11.3) 162.8 0.1 225.2 (353.7) (54.6) (408.3) (0.5) 94.5 (314.3) 17.9 278.4 (11.8) 284.5 5.4 200.8 38.4 12.4 64.4 229.1 (306.0) (45.9) (351.9) (351.9) 111.2 111.2 (11.6) 21.5 21.7 42.1 283.6 (238.7) (35.8) (274.5) (274.5) 204.2 204.2 213.3 31.3 26.2 58.5 374.7 (412.0) (61.8) (473.8) (473.8) 309.6 309.6 210.5 37.6 30.8 66.0 452.0 (248.3) (37.2) (285.6) (285.6) 153.6 153.6 320.0 34.2 26.6 60.0 505.8 (253.3) (38.0) (291.3) (291.3) 111.7 111.7 326.2 30.2 25.1 50.5 538.9 (258.4) (38.8) (297.1) (297.1) 87.4 87.4 329.2 31.8 17.0 50.1 571.8 (182.4) (27.4) (209.8) (209.8) (20.2) (20.2) 341.8 Sep-04 50.5 42.4 11.3 (6.3) (23.0) (12.0) (3.0) Sep-05 66.2 16.6 28.8 (5.7) 27.2 9.7 2.9 21.1 12.2 43.3 Sep-06 117.8 28.2 32.5 (24.4) 3.2 (5.5) (4.5) (6.9) 5.7 79.0 Sep-07e 182.7 43.2 21.7 (34.3) 17.4 (49.3) (39.0) (34.9) 6.5 Sep-08e 252.7 54.2 24.2 (44.4) 11.4 (67.4) (20.9) (15.1) 3.6 Sep-09e 339.0 69.2 29.5 (60.8) 15.8 (89.2) (29.1) (21.0) 5.3 Sep-10e 435.7 68.5 36.2 (75.6) 17.8 (114.9) (32.8) (23.6) 6.4 Sep-11e 512.7 78.6 44.2 (84.1) 16.2 (137.1) (29.8) (21.5) 5.8 Sep-12e 564.9 88.7 52.4 (90.5) 13.6 (158.1) (25.1) (18.1) 5.1 Sep-13e 606.0 94.9 60.8 (92.6) 13.5 (172.3) (24.9) (17.9) 5.4 Source: easyJet and Bryan Garnier & Company estimates 43 SkyEurope Holding AG The Eastern European low-cost champion Target price € 7.70 / Current price € 4.70 Airlines Bloomberg Reuters High / Low (€) Market Cap (€ m) EV (2007 BG Estimate) (€ m) Volume 6m Avge (in '000 Shares) Free float EPS growth 06e -09e Gearing 2006 Dividend yield YE: 31 Dec Sales (€ m) % change yoy EBIT (€ m) EBIT margin EPS (€) EV / Sales EV / EBIT P/E (x) PEG ratio 2005 112.7 143% -33.6 -29.8% -143.06 0.6 -2.1 n/a n/m 2006 158.6 41% -55.5 -35.0% -146.94 0.4 -1.1 n/a n/m 2007e 192.0 21% -33.3 -17.3% -92.21 1.4 -7.8 n/a n/m SKY AV SKYV.VI 6.65 / 1.42 183.3 259.7 234.3 95.5% n/m n/m n/a 2008e 306.7 60% 4.5 1.5% -12.88 1.3 91.3 n/a n/m 9th March 2007 Buy We initiate coverage of SkyEurope, one of Europe’s fastest growing low-cost low-fare passenger airlines, with a BUY recommendation and a target price of €7.70 representing 64% upside potential. After a “construction” period characterised by an exponential increase in passenger volumes, Sky has now put the focus on achieving profitability. In a matter of only a few years, SkyEurope’s management exploited a gap in the market to become Slovakia’s national airline by default. This launch-pad has enabled it to create hubs across Eastern Europe, and succeed where other larger players such as EasyJet have failed. SkyEurope has attracted a strong financial partner in York Capital Management with its 29.9% stake. The move stabilises both the capital and cash structure of the group. From March 2007, SkyEurope will open a new hub at Vienna International airport, operating a network of 16 European routes, significantly enlarging its addressable market. SkyEurope was severely impacted by the turmoil in emerging markets in 2006, with its share price falling an unjustified 80%. This clear overreaction negated the underlying fundamentals, and despite the recent share price recovery, we believe there remains a strong longer-term buying opportunity. SkyEurope also boasts a highly qualified and dedicated management team headed by two entrepreneurs: Alain Skowronek came with a strong sector-based background, while Christian Mandl brought an extensive and priceless knowledge in the Central & Eastern Europe market. Last but not least, the company has an outstanding agreement with Boeing for the procurement of 32 Boeing 737-700 NG signed in 2005. We estimate that the potential market gain resulting from the exercise of options on 16 of these is approximately $160m. 200 1 80 1 60 1 40 1 20 1 00 80 60 40 20 0 Sep05 No v05 Jan06 M ar06 M ay06 Jul06 Sep06 No v06 Jan07 SKY-VI DJS TM A irlin DJ EURO STOXX50 Alexandre Boukhari: +33 1 56 68 75 39 aboukhari@bryangarnier.fr SkyEurope Holding AG 2004A Revenue / Oper at i ng M ar gi n 600. 0 25. 0% 20. 0% 500. 0 15. 0% 400. 0 10. 0% 5. 0% 300. 0 0. 0% 200. 0 -5. 0% -10. 0% 100. 0 -15. 0% 0. 0 2004A 2005A 2006A 2007E 2008E 2009E 2010E T ot al s al es (€ m) E B I T DA R mar gi n -20. 0% 2005A 143.2% -9.5% 182.4% (0.0) n/m 2006A 40.7% -13.4% 65.3% (0.1) n/m 2007E 21.1% 3.5% -40.0% (0.1) n/m 2008E 59.8% 17.2% -113.4% (0.1) n/m 2009E 31.6% 19.6% 321.9% (0.0) n/m 2010E 30.8% 21.4% 84.2% 0.1 0.0 Growth Credentials Revenue growth EBITDAR margin EBIT growth Free cash flow PEG ratio Income statement (key data) Scheduled revenues Ancillary revenues Staff costs Fuel & oil EBITDAR Aircraft rentals EBITDA EBIT Net interest Tax Net income Diluted EPS (cent) Cash Flow EBIT Depreciation & amortisation Change in WCR Other Cash flow from operations Capex Change in financial debt Convertible bonds Increase in share capital Dividends paid Net cash flow CFPS (cent) Balance Sheet Tangible fixed assets Other non current assets Trade debtors Other current assets Cash and equivalent Total Assets L-T debt other non current liabilities S-T debt Other current liabilities Shareholders equity Total liabilities & shareholders equity Ratios ROCE ROE ROA Gearing Interest cover Cap ex/depreciation P/BV EV / EBITDA EV / EBIT n/m -6.2% n/a 0.0 n/a E B I T gr owt h / E P S 350. 0% 300. 0% 250. 0% 200. 0% 150. 0% 100. 0% 50. 0% 0. 0% -50. 0% -100. 0% -150. 0% Di l ut ed E P S (cent ) -200 E B I T gr owt h 2004A 2005A 2006A 2007E 2008E 2009E 2010E -150 -100 -50 0 50 39.5 6.9 (5.1) (11.0) (2.9) (8.8) (11.7) (11.9) (0.1) 3.3 (8.6) (129.2) 83.9 28.8 (13.0) (39.7) (10.7) (22.0) (32.8) (33.6) (0.4) 5.3 (28.6) (143.1) 146.6 11.9 (20.6) (61.0) (21.2) (32.7) (53.9) (55.5) (2.6) 0.8 (57.3) (146.9) 174.0 18.0 (22.1) (61.4) 6.7 (36.0) (29.3) (33.3) (2.7) (36.0) (92.2) 266.2 40.5 (30.7) (85.9) 52.6 (36.0) 16.6 4.5 (9.5) (5.0) (12.9) 353.8 49.9 (38.4) (110.8) 78.9 (45.0) 33.9 18.8 (15.2) (0.7) 2.9 7.4 458.9 69.0 (49.6) (142.0) 112.7 (63.0) 49.7 34.6 (15.5) (3.6) 15.5 39.7 Company description SkyEurope Holding AG is a low-cost airline with bases in Hungary, Poland, the Czech Republic, Austria and Slovakia. It offers a route network of 42 destinations in 19 countries from its bases in Budapest, Krakow, Prague, Vienna and Bratislava. The Company's fleet consists of 16 Boeing-737 aircraft. The Company is headquartered in Bratislava, Slovakia. (11.9) 0.2 9.6 0.5 (1.6) (1.2) (0.1) 0.0 10.0 7.2 18.3 (33.6) 0.8 8.3 0.4 (24.0) (1.3) 0.2 62.2 37.2 95.3 (55.5) 1.5 6.8 (0.7) (47.8) (17.5) 10.6 21.9 28.7 (3.9) (10.1) (33.3) 4.0 1.3 (1.5) (29.5) (67.0) 64.0 (32.5) (83.3) 4.5 12.2 8.1 (6.5) 18.2 (165.0) 153.6 6.8 17.4 18.8 15.2 11.0 (13.4) 31.5 (69.0) 41.6 4.1 10.5 34.6 15.2 16.3 (15.9) 50.2 (5.0) (28.8) 16.4 42.0 1.3 5.8 1.2 5.2 8.6 22.1 0.5 21.6 0.1 22.1 1.8 14.0 8.7 13.5 45.7 83.7 0.8 0.2 48.9 33.8 83.7 17.7 17.6 11.3 28.8 41.8 117.2 21.1 0.2 79.5 16.4 117.2 80.7 18.3 14.5 32.1 8.7 154.2 85.1 1.1 87.6 (19.6) 154.2 233.6 18.3 22.2 50.5 15.5 339.9 238.7 1.8 124.1 (24.6) 339.9 287.4 20.5 29.5 66.5 17.3 421.2 280.3 2.3 160.3 (21.7) 421.2 277.3 25.0 38.2 86.8 29.2 456.5 251.5 3.1 208.2 (6.3) 456.5 n/m n/m -39.1% n/m (201.5) 5.4 n/a n/a n/a n/m n/m -54.1% n/m (91.2) 1.6 n/m (2.2) (2.1) n/m n/m -57.0% n/m (21.3) 11.3 n/m (1.1) (1.1) -42.9% n/m -26.5% n/m (12.4) 16.8 n/m (8.9) (7.8) 1.7% n/m -2.0% n/m 0.5 13.6 n/m 24.5 91.3 6.0% -12.4% 0.8% n/m 1.2 4.6 n/m 13.2 23.8 12.1% -110.5% 3.5% n/m 2.2 0.3 n/m 8.2 11.7 45 SkyEurope Holding AG 1. Investment Case What’s changed? The entry of a new strategic shareholder in September 2006 York Capital Management’s1 entry into the share capital (29.9% pro-forma shareholding after approval of anti-monopoly authorities, rising to a potential 40% upon conversion of a €16.4m convertible loan) brings with it a validation of SkyEurope’s strategy from a market specialist and an undisputed financial partner/advisor. York has significant experience in the airline sector, having participated in the Air Canada restructuring process. It was in the process of bidding for Olympic Airways and Bulgaria Air when it decided to withdraw its offers, and invest instead in SkyEurope. To date, SkyEurope has sacrificed profitability in its drive to achieve a critical mass Over the past two fiscal years, average sales CAGRs increased by almost 100%. Management adopted an accelerated growth path in order to reach a critical size, making it impossible to achieve profitability. On average, a low-cost carrier (LCC) takes one year for a new route to attain profitability vs. three years for a traditional carrier. Nevertheless, given its heady development rate, SkyEurope was unable to focus on margin improvements. With growth henceforth limited to 30% p.a. (over the next three years), management can finally get to grips with profitability. We predict the company will turn the corner at the EBITDAR and EBIT levels by September 2007 and September 2008, respectively. A strong and well-established network From its five existing bases in Bratislava, Budapest, Krakow, Prague and Vienna, SkyEurope now services 42 destinations in 19 countries, operating 100 scheduled routes. From March 2007, SkyEurope has allocated two Boeing 737-700 NGs to its newly opened hub located at Vienna International airport, and will operate a network of 16 European routes. Valuation Our target price of €7.70 is the result of a DCF valuation. Although we do not expect Sky to make any profit from operations before 2008, and given the cyclical sector backdrop, our average WACC of 8.2% could appear aggressive. However, it reflects the future indebtedness of the company related to the purchases of aircraft, mechanically reducing the weight of the cost of equity. York Capital Management is a private investment fund based in New York with over €6bn in assets under management. 1 46 SkyEurope Holding AG Despite a low terminal growth rate of 0.5% and a beta of 1.7, our DCF model highlights significant upside potential to €7.7. In order to corroborate our DCF valuation, we have estimated the enterprise value of the group through an alternative approach based on the valuation of: 1) the 16 remaining aircraft purchase options; and 2) the value of the routes network. Catalysts An abundance of potentially positive newsflow Q2 and Q3 results on 31st May 2007 and 31st August 2007, respectively, will give investors insights into how profitability will be achieved. Secondly, there is scope to see current negotiations with Russian and Ukrainian governments resulting in new routes to Moscow, Saint Petersburg and Kiev. This extension of the network to the east would massively increase the current addressable market and generate a priceless growth opportunity. Difference from consensus The consensus is not representative, given the scant following. However, we are top-of-the-range in terms of our target price, given our more aggressive estimates for the evolution of margins. We also differentiate ourselves in the way we do not consider operating leases as financial debt. Risks Oil exposure: Within the low-cost model, jet fuel typically accounts for around 30% of total costs before depreciation and aircraft leases. The sharp rise in oil and jet fuel prices since 2003 has accordingly forced airlines to adopt hedging instruments in order to contain costs. SkyEurope implemented a hedging strategy in 2006. The Company has hedged 90% of jet kerosene purchases for 2006/2007 on the basis of US$62.5/bbl. Dollar exposure: 30-35% of SkyEurope’s cash outflows are denominated in US$. This includes fuel, maintenance and lease expenses. Management has currently hedged up to 75% of its requirement at an exchange rate of US$1.32 vs. Euro for the ongoing fiscal year Environmental issues: An increasing influence on the airline industry, with growing public awareness of climate change and local air quality issues. The debate is currently most intense in Western Europe, and is increasingly focusing on CO2 emissions, instead of the traditional area of aircraft noise. Aviation contributes to circa 3% of CO2 emissions in the EU, a low proportion vs. road traffic (22%) and power generation (39%). Currently, there is no tax on jet fuel. The airlines are lobbying against a flat tax, arguing that high oil prices are already boosting investments in fuel efficient, low-emission solutions. Fiscal exposure: SkyEurope benefits from a favourable fiscal environment. Slovakia introduced a 19% flat tax rate (corporate and personal income - almost without exceptions) in 2004. This tax scheme has a direct positive impact on the net result, but indirectly allows the company to pay lower gross wages vs. peers without any impact to employees’ net wages. Any increase in the tax rate would therefore have a negative impact on future results. However, given the flat tax rate was an initiative to boost economic growth a retraction is not envisaged short term. 47 SkyEurope Holding AG 2. Valuation 2.1. Share price SkyEurope Holding AG has been publicly listed since 27th September 2005 on the Vienna and Warsaw Stock Exchanges. SkyEurope’s share price was severely impacted during 2006 by turmoil in emerging markets and a sharp rise in the oil price. Despite SkyEurope’s strong fundamentals, its stock fell almost 80%. This was a clear over-reaction, and although there has been a marked recovery to date, we believe there remains a strong longer-term buying opportunity. Fig. 33: SkyEurope share price performance since the IPO SkyEurope share price fluctuation 200.0 180.0 160.0 140.0 120.0 100.0 80.0 60.0 40.0 20.0 May-06 Oct-05 Feb-06 Nov-05 Dec-05 Mar-06 Oct-06 Jan-06 Nov-06 Dec-06 Sep-05 Aug-06 Sep-06 Feb-07 Jun-06 Apr-06 Jan-07 Jul-06 SKY-VI DJ EURO STOXX50 DJS TM Airlin 80 per. Mov. Avg. (SKY-VI) Source: Thomson One Banker 2.2. Modelling and DCF valuation In building our model, we have detailed how revenues will develop with respect to fleet and Available Seat Kilometre (ASK) growth, load factor improvements and the expected increase in sales per passenger on the development of qualitative ancillary services. On top of this, we have built a cost and capex model of that puts the emphasis on cost cutting and economy of scale strategies derived from an increased fleet of aircraft. Our DCF model derives a target price of €7.70, indicating an upside potential of 64%. We valued SkyEurope using conservative assumptions. We have used an explicit forecast period of 10 years to September 2016. The parameters used to calculate our weighted average cost of capital (WACC) are shown in Fig.34. In our approach, we favoured an evolutive WACC as the company’s debt was minimal as of 30th September 2006, but should grow significantly over the next 3 years as its aircraft acquisition strategy 48 SkyEurope Holding AG changes. Management expects to move from a 100% leased aircraft fleet to a 50% owned/50% leased scenario. The average WACC used over the period is 8.5% (taxed WACC). Our composite beta of 1.7x is computed taking into account the beta from Bloomberg (0.60x), the economic and political risk, and a small market capitalisation. NB. We expect SkyEurope’s perceived volatility will decrease over time. Our terminal value assumes a 0.5% FCF growth rate. We believe we are conservative given the expected in increase in capacity over the period under review, and CEE growth prospects. In addition, we anticipate SkyEurope will be able to increase its revenue per passenger with the development of ancillary services, as customers are prepared to pay a little more for added extras. An EBITDA growing at nearly 30% p.a. over our explicit forecast period (from 2008 to 2016), well in excess of gross capex (12% of sales on average), also appears conservative. We expect a significant improvement in the EBIT margin to around 5% by 2009 and 13% by 2015 compared with -35% for 2006 and our -17% estimate for 2007. As competition is expected to strengthen, we do not anticipate a huge potential for price increases (we anticipate a 2% increase in scheduled revenue par passenger over the forecast period); however we do predict significant growth in ancillary revenues as SkyEurope’s offering widens in optional services. Fig. 34: WACC calculation Assumptions Tax rate Risk free rate Risk premium Beta Cost of equity Cost of debt After-tax cost of debt Average WACC (cost of capital) Source: Bryan Garnier & Company estimates 19.0% 3.8% 5.0% 1.7x 12.3% 6.0% 4.9% 8.5% 49 SkyEurope Holding AG Fig. 35: DCF model, FY06/07e-16/17e DVF Valuation (Euro m) Sales growth EBITDA margin Capex Free cash flow WACC Cumulative WACC NPV of FCF Total NPV Add: excess cash Add: financial investments Less: debt Valuation Number of shares outstanding (k) Theoretical value per share (€) 21.1 300.9 39.0 7.7 06/07e 21.1% -15.3% (67.0) (89.3) 9.9% 1.10 (81.2) 280.2 41.8 07/08e 59.8% 5.4% (165.0) (141.1) 8.1% 1.19 (118.8) 08/09e 31.6% 8.4% (69.0) (29.9) 7.8% 1.28 (23.3) 09/10e 30.8% 9.4% (5.0) 50.0 8.0% 1.38 36.1 10/11e 16.2% 11.9% (37.0) 33.6 8.0% 1.49 22.5 11/12e 8.8% 13.5% (37.0) 43.8 8.0% 1.61 27.2 12/13e 7.3% 14.4% (5.0) 86.0 8.2% 1.75 49.3 13/14e 7.2% 14.7% (5.0) 95.0 8.6% 1.90 50.1 14/15e 5.6% 15.1% (5.0) 102.3 9.0% 2.07 49.5 15/16e Term. Val. 5.6% 15.2% (5.0) 108.7 9.4% 2.26 48.1 5.6% 6.0% (5.0) 499.1 9.4% 2.26 220.8 Source: Bryan Garnier & Company estimates 2.3. Sensitivity The table below shows the effect of changes in the terminal FCF growth rate and beta on the target price. It illustrates that even using a more conservative terminal FCF growth rate of 0.0% and a beta of 2.0x implying a WACC of 9.2%, we derive a fair value of €6.4, which demonstrates today’s severe undervaluation. Fig. 36: Sensitivity of fair value (€) to terminal growth rate and beta Beta 1.40 -0.5% Terminal growth rate 0.0% 0.5% 1.0% 1.5% 8.3 8.7 9.1 9.5 10.1 1.50 7.9 8.2 8.6 9.0 9.5 1.60 7.5 7.8 8.1 8.5 8.9 1.70 7.1 7.4 7.7 8.1 8.4 1.80 6.8 7.0 7.3 7.6 8.0 1.90 6.5 6.7 6.9 7.2 7.5 2.00 6.1 6.4 6.6 6.8 7.1 Source: Bryan Garnier & Company estimates 2.4. SkyEurope is undervalued vs. peers In the table on page 7, we compare our valuation to the current pricing of the main listed European airlines (both LCC and national airlines) in term of multiples. This yields only a limited insight, as the main emphasis is on SkyEurope flying into profit at the EBITDAR and EBIT level from 2007 and 2008 onwards respectively. The company’s earnings multiples are therefore substantially above those of its peers. 50 SkyEurope Holding AG 3. SkyEurope’s intrinsic value: an alternative valuation method 3.1. An outstanding contract with Boeing In 2003 and 2004, Airbus won a large number of contracts for the procurement of aircraft to low-cost carriers. In a bid to maintain its market share, Boeing offered juicy terms. When SkyEurope management met Boeing in Seattle in January 2005, Boeing granted SkyEurope an impressive discount for the purchase of 32 Boeing 737-700 NGs available for delivery between 2006 and 2010. The agreed aircraft unit price has not been disclosed for confidential purposes (the list price before standard discount is circa $54m). From the information available, we calculate that if SkyEurope were to sell the 16 aircraft on the spot market upon the exercise of the remaining purchase options, it would incur a $160m capital gain. 3.2. A highly efficient network in Central and Eastern Europe makes SkyEurope a takeover target Fig. 37: SkyEurope Routes Network 51 SkyEurope Holding AG SkyEurope has never sacrificed quality. In direct contrast to traditional carriers and LCCs operating in Central and Eastern Europe which encountered financial difficulties resulting in inefficient networks, and often sub-standard service quality, SkyEurope became the reference airline in Eastern Europe. As a consequence, SkyEurope is a logical takeover target within the CEE. Using as a benchmark Ryanair’s offer for Aer Lingus of €1.5bn, representing 1.35x estimated 2006 sales and 8.1x estimated EBITDA, we derive an equity value for SkyEurope. Given that SkyEurope will not derive any profit for the next 2 years, we apply a 25% discount to the trading multiple and derive an equity value of circa €181m excluding the Boeing intrinsic contract value of circa €120m (exchange rate €1 = $1.33). Through this alternative valuation approach, we value SkyEurope at roughly €8 per share, in line with our DCF valuation approach. 52 SkyEurope Holding AG 4. SkyEurope: a play on Eastern Europe growth Being the “first-mover” allowed SkyEurope to progressively become the largest low-cost carrier in Central & Eastern Europe (CEE) gaining a strong local expertise. The Company has largely invested in its brand, adapting its distribution network and product offering to local conditions. SkyEurope operated five bases by the end of February 2007 (Bratislava, Budapest, Krakow, Prague and Vienna), offering short-haul “point-to-point” scheduled services to 42 cities in 19 European countries over a network of 100 scheduled routes. In addition, being headquartered in Bratislava, Slovakia, and given Slovak Airline’s bankruptcy, SkyEurope became the “de facto” Slovak national carrier, accessing 50% of the Bratislava airport scheduled traffic of Bratislava airport in 2005. Paradoxically, competition in the airline industry is much tougher in Western Europe, where the market is much more mature vs. the CEE. Thus, one of the strengths of SkyEurope is that through its leadership, it avoided competition with other major LCCs. Only 5 out of 100 routes are in direct competition with largest LCC rivals (namely Ryanair and EasyJet). SkyEurope is therefore principally competing with legacy network carriers within the CEE (Malev, CSA, LOT, Austrian Airlines etc), which are facing tremendous financial difficulties related to the extension of the European Union. Within a deregulated sector, EU members are no longer allowed to finance their state-owned airlines. Reaching its critical mass with an extended fleet of 16 new Boeing 737-700 NGs, and for the first time in a position to realise significant economies of scale, enabling a reduction of unit costs and improvement of yield, SkyEurope is now ready to address one of the most dynamic parts of Europe. In 2006, Central Europe countries exhibited a GDP growth in the area of 6% (cf. Fig. 38). Fig. 38: GDP growth - 2006e 1 0.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1 .0% 0.0% 8.6% 5.6% 5.1 % 4.7% 4.7% 4.6% 3.9% 1 .6% Slo vakia Czech Republic B ulgaria P o land Hungary Ro mania Cro atia EU 1 5 Source: Economist Intelligence Unit, Global Insight, Eurostat 53 SkyEurope Holding AG In this part of Europe where the penetration of air travel is considered low compared to the EU 15 average, there are huge opportunities for low-cost, no-frill carriers used to fly people point-to-point at much cheaper rates, leading to high growth potential for passenger traffic. Fig. 39: Flights per capita - 2004 2.5 2.0 1 .5 1 .0 1 .0 0.5 Ro mania Slo vakia P o land Cro atia B ulgaria Hungary Czech Republic EU 1 5 0.1 0.2 0.2 0.3 0.6 0.6 2.2 Source: IATA In 2006, we expect passenger traffic growth in the area of 12% for the CEE compared to 4.7% for the EU 15. Fig. 40: Passenger traffic growth - 2006e 1 4.0% 1 2.0% 1 0.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1 2.0% 1 % 0.1 9.7% 9.3% 7.3% 6.5% 5.5% 4.7% P o land Slo vakia Czech Republic Hungary B ulgaria Cro atia Ro mania EU 1 5 EU 1 5 SkyEuro pe bases SkyEuro pe CEE destinatio ns Source: IATA 54 SkyEurope Holding AG 5. Financial overview The consolidated financial statements of SkyEurope Holding AG presented below, are prepared in accordance with the International Financial Reporting Standards (IFRS), as adopted by the European Union. 5.1. Per share data Fig. 41: Per share data (€) (€) Averg. n° of shares - basic (k) Averg. n° of shares - diluted (k) Basic EPS (€ cent) EPS growth CFPS Sep-04 6,683 n/a (129.2) n/m n/a Sep-05 20,000 n/a (143.1) n/m 1.86 Sep-06 38,990 n/a (146.9) n/m -0.10 Sep-07e 38,990 n/a (92.2) n/m -0.85 Sep-08e 38,990 n/a (12.9) n/m 0.17 Sep-09e 38,990 n/a 7.4 n/m 0.05 Sep-10e 38,990 n/a 39.7 439.6% 0.30 Sep-11e 38,990 n/a 87.0 119.3% 0.70 Sep-12e 38,990 n/a 120.5 38.5% 0.87 Sep-13e 38,990 n/a 152.0 26.1% 1.09 Source: SkyEurope and Bryan Garnier & Company estimates 5.2. Enterprise value Fig. 42: Enterprise value (€m) (€m) Market cap. + cash - debt Enterprise value (EV) Sep-04 n/a n/a n/a n/a Sep-05 116.2 45.7 0.0 70.5 Sep-06 81.9 41.8 21.1 61.2 Sep-07e 183.3 8.7 85.1 259.7 Sep-08e 183.3 15.5 238.7 406.5 Sep-09e 183.3 17.3 280.3 446.3 Sep-10e 183.3 29.2 251.5 405.6 Sep-11e 183.3 56.6 254.7 381.4 Sep-12e 183.3 90.6 254.7 347.4 Sep-13e 183.3 133.0 219.5 269.8 Source: Bryan Garnier & Company estimates 5.3. Stock market ratios Fig. 43: Stock market ratios (€m) P/E (x) P/CF (x) Dividend yield EV/Sales EV/EBITDAR EV/EBITDA EV/EBIT Sep-04 n/a n/a n/a n/a n/a n/a n/a Sep-05 -4.1 3.1 n/a 0.6 -6.6 -2.2 -2.1 Sep-06 -1.4 -20.9 n/a 0.4 -2.9 -1.1 -1.1 Sep-07e -5.1 -5.5 n/a 1.4 38.6 -8.9 -7.8 Sep-08e -36.5 27.0 n/a 1.3 7.7 24.5 91.3 Sep-09e 63.9 99.3 n/a 1.1 5.7 13.2 23.8 Sep-10e 11.8 15.5 n/a 0.8 3.6 8.2 11.7 Sep-11e 5.4 6.7 n/a 0.6 2.8 5.2 6.8 Sep-12e 3.9 5.4 n/a 0.5 2.3 3.9 4.8 Sep-13e 3.1 4.3 n/a 0.4 1.6 2.6 3.2 Source: SkyEurope and Bryan Garnier & Company estimates 55 SkyEurope Holding AG 5.4. Profit & Loss Account Fig. 44: P&L statement, 2004-13e (€m) Scheduled revenues Ancillary revenues Total sales Staff costs Fuel & oil Maintenance, materials & repairs Marketing & distribution costs Aircraft and traffic servicing Other Expenses EBITDAR Aircraft rentals EBITDA Depreciation & Amortisation EBIT Interest income Interest expense Pre-tax profit Taxes Net income Financial ratios Sales growth EBITDAR margin EBITDA margin EBIT margin ROA ROE ROI ROCE Gearing n/a -6.2% -25.2% -25.7% n/m n/m n/m n/m n/m 143.2% -9.5% -29.1% -29.8% n/m n/m n/m n/m n/m 40.7% -13.4% -34.0% -35.0% n/m n/m n/m n/m n/m 21.1% 3.5% -15.3% -17.3% n/m n/m n/m n/m n/m 59.8% 17.2% 5.4% 1.5% n/m 22.7% n/m 1.7% n/m 31.6% 19.6% 8.4% 4.7% 0.8% -12.4% 1.1% 6.0% n/m 30.8% 21.4% 9.4% 6.6% 3.5% -110.5% 6.3% 12.1% n/m 16.2% 22.1% 11.9% 9.2% 6.9% 317.2% 12.0% 18.6% n/m 8.8% 22.9% 13.5% 10.8% 8.4% 91.9% 14.3% 22.4% n/m 7.3% 23.6% 14.4% 11.9% 9.7% 56.8% 16.8% 28.4% 64.6% Sep-04 39.5 6.9 46.3 (5.1) (11.0) (4.9) (5.2) (18.8) (4.3) (2.9) (8.8) (11.7) (0.2) (11.9) (0.1) (11.9) 3.3 (8.6) Sep-05 83.9 28.8 112.7 (13.0) (39.7) (8.4) (8.1) (45.1) (9.1) (10.7) (22.0) (32.8) (0.8) (33.6) (0.4) (33.9) 5.3 (28.6) Sep-06 146.6 11.9 158.6 (20.6) (61.0) (16.8) (10.3) (58.5) (12.6) (21.2) (32.7) (53.9) (1.5) (55.5) (2.6) (58.1) 0.8 (57.3) Sep-07e 174.0 18.0 192.0 (22.1) (61.4) (14.4) (12.5) (61.4) (13.4) 6.7 (36.0) (29.3) (4.0) (33.3) 0.5 (3.2) (36.0) (36.0) Sep-08e 266.2 40.5 306.7 (30.7) (85.9) (15.3) (17.9) (85.9) (18.4) 52.6 (36.0) 16.6 (12.2) 4.5 0.2 (9.7) (5.0) (5.0) Sep-09e 353.8 49.9 403.7 (38.4) (110.8) (20.0) (22.4) (109.0) (24.2) 78.9 (45.0) 33.9 (15.2) 18.8 0.4 (15.6) 3.6 3.6 Sep-10e 458.9 69.0 527.9 (49.6) (142.0) (25.9) (28.8) (137.2) (31.7) 112.7 (63.0) 49.7 (15.2) 34.6 0.6 (16.0) 19.2 (3.6) 15.5 Sep-11e 528.8 84.7 613.5 (57.1) (161.7) (29.8) (32.7) (159.5) (36.8) 135.9 (63.0) 72.9 (16.7) 56.2 1.0 (15.2) 42.0 (8.0) 34.0 Sep-12e 575.2 92.2 667.3 (61.5) (174.1) (32.1) (35.3) (171.8) (39.6) 153.0 (63.0) 90.0 (18.2) 71.8 1.6 (15.3) 58.1 (11.0) 47.1 Sep-13e 617.4 98.9 716.3 (65.4) (185.0) (34.1) (37.5) (182.5) (42.5) 169.3 (66.0) 103.3 (18.2) 85.2 2.3 (14.2) 73.2 (13.9) 59.3 Source: SkyEurope and Bryan Garnier & Company estimates 56 SkyEurope Holding AG 5.5. Balance Sheet Fig. 45: Balance sheet, 2004-13e (€m) Cash & marketable securities Trade receivables Other receivables Inventories Other current assets Current Assets Net fixed and intangible assets Long-term receiv. and other assets Deferred Tax assets Total assets Trade payables Unearned transport income Provisions Current Liabilities Provisions Financial debt Convertible bonds Other non-current liabilities Long Term Liabilities Issued share capital Share premium account Retained Earnings Other reserves Profit/Loss for the year Total Liab. & Shareholder Equity Sep-04 8.6 1.2 4.4 0.4 0.4 15.0 1.3 2.4 3.3 22.1 13.2 7.7 0.6 21.6 0.2 0.3 0.5 0.2 17.4 (8.8) (0.1) (8.6) 22.1 Sep-05 45.7 8.7 11.6 0.6 1.3 67.9 1.8 5.3 8.7 83.7 33.4 14.5 0.9 48.9 0.6 0.2 0.2 1.0 20.0 59.8 (17.4) (28.6) 83.7 Sep-06 41.8 11.3 25.7 1.1 2.0 81.9 17.7 8.3 9.3 117.2 53.2 22.7 3.6 79.5 0.1 10.9 10.2 0.1 21.3 39.0 81.3 (46.0) (0.6) (57.3) 117.2 Sep-07e 8.7 14.5 28.8 1.2 2.1 55.3 80.7 9.0 9.3 154.2 55.3 27.5 4.8 87.6 0.2 74.9 10.2 1.0 86.2 39.0 81.3 (103.3) (0.6) (36.0) 154.2 Sep-08e 15.5 22.2 46.0 1.3 3.2 88.1 233.6 9.0 9.3 339.9 72.5 43.9 7.7 124.1 0.2 228.5 10.2 1.5 240.5 39.0 81.3 (139.3) (0.6) (5.0) 339.9 Sep-09e 17.3 29.5 60.6 1.7 4.2 113.3 287.4 11.3 9.3 421.2 92.4 57.7 10.1 160.3 0.3 270.1 10.2 2.0 282.7 39.0 81.3 (144.3) (0.6) 2.9 421.2 Sep-10e 29.2 38.2 79.2 2.2 5.5 154.3 277.3 15.8 9.3 456.5 119.5 75.5 13.2 208.2 0.4 241.3 10.2 2.6 254.6 39.0 81.3 (141.4) (0.6) 15.5 456.5 Sep-11e 56.6 44.1 92.0 2.5 6.3 201.5 297.6 15.8 9.3 524.1 135.2 87.7 15.3 238.2 0.5 244.5 10.2 3.1 258.3 39.0 81.3 (126.0) (0.6) 33.9 524.1 Sep-12e 90.6 47.9 100.1 2.7 6.9 248.2 316.5 15.8 9.3 589.7 144.3 95.4 16.7 256.4 0.5 244.5 10.2 3.3 258.6 39.0 81.3 (92.0) (0.6) 47.0 589.7 Sep-13e 133.0 51.4 107.4 2.8 7.4 302.1 303.3 16.5 9.3 631.2 153.3 102.4 17.9 273.6 0.6 209.3 10.2 3.6 223.7 39.0 81.3 (45.0) (0.6) 59.3 631.2 Source: SkyEurope and Bryan Garnier & Company estimates 57 SkyEurope Holding AG 5.6. Cash Flow Statement Fig. 46: Cash flow statement, 2004-13e (€m) EBIT (+) Depreciation & amortisation (+) Foreign exchange gains/losses (-) Financial income (+) Financial interests paid (+/-) increase / decrease in provisions (-) Tax paid (+/-) change in trade receivables (+/-) change in other current assets (+/-) change in inventories (+/-) change in accounts payable (+/-) change in other creditors CF from operating activities (-) Capital expenditures - aircraft (-) Capital expenditures - other tangible assets (-) Other investing Cash Flows CF from investing activities (+/-) Change in financial debt (+) Convertible bonds - equity portion (+) Convertible bonds (+) Issue of share capital CF from financing activities Other Change in Cash and equivalents 10.0 9.9 1.4 8.6 62.2 62.5 37.2 11.7 10.2 28.7 61.3 (3.9) 64 (33.1) 154 6.8 42 1.8 (29) 11.9 3 27.4 34.0 (35) 42.4 (1.2) (1.2) (0.1) (1.3) (1.3) 0.2 (17.5) 10.6 (3.0) (0.7) (67.7) 64.0 (5.0) (165.0) 153.6 (5.0) (2.3) (71.3) 41.6 (5.0) (4.5) (9.5) (28.8) (5.0) (37.0) 3.2 (5.0) (37.0) (5.0) (0.8) (5.8) (35.2) 0.7 (4.9) (0.2) 14.5 0.1 (1.6) 0 0.7 (17.5) (0.9) (0.2) 27.0 (24.0) 0 2.3 (19.8) (0.7) (0.5) 28.0 (0.1) (47.8) (17.5) 1.2 (3.2) (3.2) (0.1) 6.9 0.9 (29.5) (64.0) 3.0 (7.7) (18.3) (0.1) 33.6 0.6 18.2 (160.0) 2.5 (0.7) (7.3) (15.6) (0.4) 33.8 0.5 31.5 (64.0) 3.2 (3.6) (8.8) (19.9) (0.5) 44.9 0.6 50.2 0.0 2.2 (8.0) (5.8) (13.7) (0.3) 27.9 0.4 61.2 (32.0) 1.4 (11.0) (3.9) (8.6) (0.2) 16.9 0.3 71.0 (32.0) 1.3 (13.9) (3.5) (7.9) (0.2) 15.9 0.2 83.3 Sep-04 (11.9) 0.2 (0.2) Sep-05 (33.6) 0.8 (0.2) 0.1 (0.1) Sep-06 (55.5) 1.5 (3.2) 0.3 (0.1) Sep-07e (33.3) 4.0 0.5 (3.2) Sep-08e 4.5 12.2 0.2 (9.7) Sep-09e 18.8 15.2 0.3 (15.6) Sep-10e 34.6 15.2 0.5 (16.0) Sep-11e 56.2 16.7 0.9 (15.2) Sep-12e 71.8 18.2 1.5 (15.3) Sep-13e 85.2 18.2 2.2 (14.2) Source: SkyEurope and Bryan Garnier & Company estimates 58 Low-cost airlines 8. Appendix A - Network airlines vs. low-cost airlines (LCCs) There is no standard business model or definition for an LCC. The term itself incorporates a wide range of airlines with significant differences in the type of routes and the level of passenger service offered. For example, Ryanair in Europe is a pure no-frills airline, flying from secondary airports and targeting customers through ultra-low prices. By contrast, JetBlue in the US offers some passenger services (e.g. in-flight TVs), flies into major airports and promotes itself as offering the “best service at low prices”. Yet both airlines are viewed as LCCs. The airline’s own strategy and value proposition will determine whether it promotes itself to potential customers as an LCC. In general, an LCC would include the following characteristics, at least to some degree: Primarily point-to-point operations. Serving short-haul routes, often to/from regional or secondary airports. A strong focus on price sensitive traffic, mostly leisure passengers. Typically one service class only, with no (or limited) customer loyalty programmes. Limited passenger services, with additional charges for some services (e.g. on-board catering). Low average fares, with a strong focus on price competition. Different fares offered, related to aircraft load factors and/or length of time before departure. A very high proportion of bookings made through the Internet. High aircraft utilisation rates, with short turnaround times between operations. A fleet consisting of just one or two types of aircraft. A simple management and overhead structure with a lean strategic decision-making process. 59 Low-cost airlines 9. Appendix B – Industry Statistics Fig. 47: System-wide global commercial aviation 2000 Revenues, US$ billion Passenger Cargo Traffic volume growth % Passenger Cargo World economic growth % Yield growth % Yield growth, inflation/ex rate adjusted % Expenses, US$ billion Fuel % of operating expenses Crude oil price, Brent, US$/barrel Jet fuel price, Brent, US$/barrel Gallons used/100 Tonne Km performed Non-fuel Cents per Available Tonne Kilometre % change % change, adjusted for ex rate Operating profit, US$ billion % margin Net profit, US$ billion % margin 9.6% 9.2% 4.7% -1.8% -3.0% 318 46 14% 28.8 36.7 11.3 272 37.9 -2.9% -0.9% 10.7 3.3% 3.7 1.1% -2.9% -6.3% 1.6% -2.5% -2.6% 319 43 13% 24.7 30.5 11.8 276 38.5 1.7% 4.4 (11.8) -3.8% (13.0) -4.2% 0.1% 6.1% 1.7% -2.4% -4.6% 311 40 13% 25.1 29.1 11.3 271 37.8 -1.7% -2.4 (4.9) -1.6% (11.3) -3.7% 1.5% 4.3% 2.6% 2.7% -4.9% 323 44 14% 28.8 34.7 11.0 279 38.2 1.1% -4.3 (1.5) -0.5% (7.6) -2.4% 13.9% 11.9% 4.1% 3.9% -2.6% 375 61 16% 38.3 49.7 10.6 314 38.9 1.9% -1.9 3.3 0.9% (5.6) -1.5% 7.3% 2.7% 3.6% 3.1% -1.3% 409 91 22% 54.5 71.0 10.4 318 37.2 -4.4% -5.6 4.3 1.0% (3.2) -0.8% 6.5% 5.5% 3.9% 2.6% -0.3% 441 115 26% 68.0 84.0 10.2 326 36.1 -3.0% -3.5 9.8 2.2% (1.7) -0.4% 329 256 40 2001 308 239 39 2002 306 238 38 2003 322 249 40 2004 379 294 47 2005 413 325 50 2006e 450 359 54 Source: IATA - October 2006 60 Low-cost airlines 10. Appendix C – Dow Jones Stoxx TMI Airlines [5751] Fig. 48: Dow Jones Stoxx TMI Airlines components Total Components (9) 1 2 3 4 5 6 7 8 9 Air France – KLM Alitalia British Airways Easy Jet FL Group HF Iberia Lufthansa B Ryanair SAS Weight 19.26% 2.47% 15.19% 5.08% 4.81% 5.72% 15.92% 28.14% 3.40% Source: Dow Jones sector indice 61 Low-cost airlines 11. Appendix D – Index of abbreviations Fig. 49: Glossary Abbreviation AF ASK BA EZJ IATA IBLA LHA LCC Passenger load factor Passenger-kilometre Point-to-point traffic RPK RYA SKY Yield Explanation Air France-KLM Available seat-kilometres - Total number of seats available for the transportation of paying passengers multiplied by the number of kilometres flown. British Airways easyJet International Air Transport Association Iberia Lufthansa Low-cost carrier Revenue passenger-kilometres (RPK) divided by the number of available seatkilometres (ASK). Revenue passenger kilometres are computed by multiplying the total number of paying passengers by the kilometres they have flown. Traffic between two airports excluding all passengers taking a connecting flight. Revenue passenger-kilometre - One fair-paying passenger transported one (RPK) kilometre. 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