Ryanair's cost leadership strategy and financial performance analysis

Ryanair

Introduction & Recent History

Ryanair is a leading discount airline based in Dublin. The company is known for its cost leadership strategy that has included some attention-getting publicity stunt ideas, and some that the company has actually implemented. The company is profitable, earning €544 million in the first half of fiscal 2012 and €400 million in fiscal 2011. The company flies low-cost scheduled flights around Europe and to nearby destinations in the Mediterranean regions. Ryanair was first mover in its industry, but now faces competition from a number of other budget carriers.

In its reports, the company outlines some of the factors that have an impact on the financial statements. One of its major hubs is in Dublin, and that airport has increased fees substantially of late, making that airport less viable for all airlines. Fuel costs have risen 37pc in the past six months, squeezing the company's margins. Ryanair is still expanding routes, however, despite the difficult economic conditions and some consolidation among its competitors. That said, some flights on existing routes have been rationalized for a net traffic reduction of around 4pc. The company also suffered financial in fiscal 2011 from the weather problems in December that affected its UK and Irish hubs.

While the current focus for Ryanair is on expanding its European network and adding new bases, the company is also contemplating the possibility of moving into the trans-Atlantic market (Galbraith, 2011). The company is also supporting the development of the C919 by Chinese manufacturer Comac, which would be the third player in the large aircraft industry (Areddy & Galbraith, 2011). The latter strategy would be risky for the company. This new company, while presumably competing on a low-cost strategy, would have no safety track record. Consumers may be skeptical of the new planes as a result, and Ryanair could have more mechanical issues as well, leading to a reduction in on-time flights.

The basic strategy of Ryanair, however, is sound. The company has continued to focus on its core markets, and continued to devise schemes to help improve its bottom line. For a cost leader, the latter may generate amusing headlines but exploring all options to maintain cost leadership is an essential component of the strategy. Ryanair's fuel strategy, another key component of cost leadership, is aggressive. The company is 90% hedged for fiscal year 2012, and at higher prices than the current market price. The company is also hedged 90% through 2013 and 50% for 2014 at prices significant higher than the current market prices. Whether these strategies pay off will only be determined by the spread between the hedge prices and the market price in these years.

There is a question of whether or not Ryanair's continued expansions into ever-smaller markets is going to lead them past the point of diminishing returns. The low-cost model has been successful in attracting fliers to destinations they otherwise would not go, and this helps the companies load factors on flights to small destinations. In the long-run, however, Ryanair may be forced to look outside of Europe for growth opportunities, as the European discount air market becomes saturated.

Financial Trends

Based on the income statements for FY2011, FY 2010 and FY2009, Ryanair has seen an improvement in its revenue growth for 2011. From 2009 to 2010, Ryanair's revenue fell slightly and the company only restored profitability because oil and gas costs declined, as most other costs increased. The 2011 fiscal year was something of a recovery for the company, with top line revenue increasing by 21.6% for the year. Profit increased 22.7% in fiscal year 2011. This recovery coincides with new routes and an increase in consumer demand for the year. Thus far, 2012 is ahead of the pace set for FY2010.

The company's profit margins are becoming healthy again. For FY 2011, Ryanair's operating margin was 13.5%, compared with 13.4% in 2010 and just 3.1% for 2009. The net margin is also increasing, with the company recording a net margin of 10.3% for FY 2011, compared to 10.2% for FY 2010 and a loss in FY 2009. That the company was able to increase the margin even as fuel prices increased shows that Ryanair exhibited strong cost controls in FY2011. Fuel costs as a percentage of revenue jumped from 29.9% in FY 2010 to 33.8% in FY2012. Thus, Ryanair has been able to cut costs elsewhere in order to make up for this jump, most notably in the areas of marketing and airport charges, both of which fell relative to revenue.

Ryanair touts its balance sheet as one of its primary strengths. An analysis of the company's liquidity shows that Ryanair is in good financial health. The company's current ratio is 1.89, compared with 1.97 in FY 2010 and 1.84 in FY 2009. Most of the company's current assets are in cash or equivalents, so the company's cash ratio is healthy as well. The cash ratio for FY 2011 is 1.1, compared with 0.95 in FY 2010 and 1.15 in FY 2009. Trade payables compared to turnover are lower than they were two years ago, indicating that the company is not trying to stretch payments in order to make ends meet.

In terms of long-term solvency, Ryanair has a debt-equity ratio of 1.91, compared with 1.65 in FY 2010 and 1.63 in FY 2009. The company, however, is steadily adding to its long-term debt, which has climbed 50% since FY 2009, compared to an increase in retained earnings of just 10.6% in the same period. The company has an efficient operation. It has low amounts of receivables, leading to a high receivable turnover.

Ryanair's taking on of long-term debt coincides with increase the company's fixed assets, something that would be expected on account of the added routes, but does not correspond with a predicted decrease in traffic. Fixed assets (mostly aircraft) has increased 35.3% since FY 2009, while scheduled revenue increased only 20.6% in that time. This points to the company earning less for each aircraft -- hinting that perhaps it is reaching the point of diminishing returns on new routes. The new aircraft being added are not as profitable as the older ones. Thus, paying down the debt on those new aircraft will take longer. This might be one of the reasons why the company is seeking aircraft from China, as a means of reducing the cost of servicing new routes, knowing that those new routes will either have lower load factors or that the airline will have to run fewer flights on the newer routes.

Cost of Capital

The weighted average cost of capital is used to determine what it costs the company for the money it invests (Investopedia, 2011). The WACC calculation is as follows:

The weighting of debt and equity at Ryanair can be determined from its balance sheet. The figures used in this calculation will derive from the latest full-year report, FY 2011. The total debt and equity on the balance sheet is €8596.0. The total equity on the balance sheet is €2953.9 and the total liabilities on the balance sheet are therefore €5642.1. This means that the weight for debt is 65.6% and the weight for equity is 34.4%.

The next step is to determine the cost of equity and the cost of debt. The cost of equity can be calculated using the capital asset pricing model (CAPM). The principle behind CAPM is that the cost of a firm's equity relates to the risk of that equity. Equity risk is measured by the beta, which measures the correlation of the stock's daily returns vs. The market's daily returns. The beta can be found using Yahoo! Finance. For Ryanair, the beta is 0.38 (Reuters, 2011). The CAPM formula is as follows:

rE = rF + betalevered ( rM - rF )

source: QuickMBA.com

The risk free rate can be taken as the one-year yield of British treasuries, which is 0.43% according to the Financial Times. The historical market return on the FTSE All-Shares is around 5% per year, according to FTSE (2007). When these figures are applied to the capital asset pricing model, the cost of equity for Ryanair is as follows:

Ra = 0.43 + (0.38)(5-.43) = 2.17%

The cost of debt for Ryanair can be examined by finding out the current yield on its bond issues. According to the 2011 Annual Report, the weighted average interest rate on cumulative borrowings was 2.9%. That the cost of debt is higher than the cost of equity at present reflects a couple of key factors. The first is that a substantial part of Ryanair's debt is in the form of financing on its aircraft, rather than corporate bonds. Such financing will usually be a higher rate than bonds. Additionally, some of the company's debt was taken out during higher-rate environments. It is conceivable that the current yields on this debt are lower than the company's cumulative cost of debt. The other factor is low beta of the firm's stock. This low volatility makes Ryanair much less risky that most securities on the London Stock Exchange and again this lowers the company's cost of equity. Lastly, the low returns on the LSE over the past ten years contribute to a low cost of equity. Historic market returns derived from the FTSE 100 are higher, and returns derived from a longer time series might also be higher.

These figures can then be used to calculate the weighted-average cost of capital for Ryanair:

WACC = (.656)(2.9) + (.344)(2.17)

WACC = 1.9024 + 0.74648 = 2.65%

This cost of capital is very low. It is necessary, however, for Ryanair to maintain a low cost of capital because of the emphasis on cost leadership in its model. That the company has been able to maintain this low cost of capital has been a valuable asset. Going forward, it is likely that the company's weighting on debt will increase. Ryanair has noted in its reports that it still has plans for further ambitious expansion. This expansion will require additional aircraft and the company expects that the new aircraft will be financed entirely by debt. Rising debt levels are already contributing to higher interest payments, but as long as the cost of debt remains low, this is not a serious concern. Should the cost of debt increase, however, then Ryanair could see its liquidity position diminish.

Dividend Policy

Ryanair does not pay a regular dividend. As noted in the 2011 Annual Report, the company did pay a special dividend of €500million in the 2011 fiscal year. Also noted, "the company has indicated that it may pay a further dividend of up to €500 million before the end of fiscal year 2013, subject to…continued profitability and the absence of…further capital expenditures." It is probably worth noting that Ryanair in other sections of the same report predicts that it will purchase more aircraft, precisely the type of capital expenditure that would preclude any further dividend.

Aside from the special dividend, Ryanair does not anticipate introducing a permanent, regular dividend to its financing structure. The company operates on a growth model, and most growth companies prefer to plow back earnings into the company. The stated policy indicates that this is the approach Ryanair expects to take, as it will only pay a further dividend if it does not plow back money into aircraft or other capital expenditures. Thus, the dividend policy at Ryanair is typical of other firms that are growing, and unless Ryanair's business enters maturity it can be expected that there will not be any further changes to this policy.

Equity Value

There are a number of factors that go into a company's equity value. First, the current information should be noted. The current share price for Ryanair is €3.781. The current market capitalization for Ryanair is €5.53 billion and the price/earnings ratio is 11.39 (Yahoo! Finance UK, 2011). The book value of the company's equity is €3176.6, and there are 1484.1 million shares outstanding. This implies a book value of 3176.6 / 1484.1 = €2.14 per share.

The book value per share should be the minimum value of the firm's share price, and this is the case currently. The P/E ratio implies that the firm is not expected to enjoy substantial growth, but rather measured growth over the foreseeable future. This is a reasonable assessment, given the growth constraints of Ryanair's current operations and the challenges it faces. The growth prospects -- and P/E -- should improve if the company can lower the cost of acquiring new aircraft or if it can begin to compete in the Trans-Atlantic market. Alternately, Ryanair can see improved performance if the fuel price is lowered.

One method of valuing equity other than book value per share, is the Gordon Growth Model. This model requires regular dividends, however, in order to value the company. Since we have the cost of capital, we would be able to use the €500 million dividend, which equates to 33.6p per share, in this model. We can assume no growth rate. The model yields a share value as follows:

.336 / 2.65% = €12.71

Clearly, the market is not pricing in regular dividends of this nature. Again, given the stated intentions of the company, this assessment is entirely reasonable. There is no guarantee of any future €500 million dividend, much less a regular one. If Ryanair were to institute a regular dividend it would likely be significantly lower, remembering that the net income for FY 2011 was only €400 million.

Another method of valuing the firm's equity is to discount its future income. The current net income is €400. If it is assumed that this will be earned in perpetuity, this implies a present value of €15,094. Again, this is a very high valuation. The market does not assume that Ryanair will be able to maintain its current record of performance. It may be that the company is somewhat undervalued, but ultimately the market has assessed the performance of Ryanair, the supply and demand drivers in the industry and made a determination that the company's current performance is unlikely to be repeated. This implied present value is €9.51 per share, about triple the current market value. The market's confidence in Ryanair, therefore, is not great.

Conclusion

Ryanair is a well-performing company in a challenging industry. The company has restored profitability after a difficult FY 2009 that was brought about by high fuel prices in the calendar year of 2008. The recovery of profits, however, has not translated to a corresponding strong stock price. The implied valuation using either the Gordon Growth Model or the discounted cash flow model is much higher than the current market cap.

There is, however, good reason to be pessimistic about Ryanair, when its operations are analyzed. The company is subject to fuel price volatility and has already hedged the coming two years at rates much higher than the current market rates. In addition, there are limited growth opportunities. What opportunities remain in the company's core European market are past the point of diminishing returns. There is already evidence to support this, that new aircraft are not earning as much as the company's older aircraft (more established routes between more popular destinations).

As a result of this analysis, it is concluded that the current valuation of Ryanair, while lower than the valuation that is implied in the analysis, is reasonable. There is good reason to believe that the company's future performance is not going to be as good as its current performance, and therefore the implied growth should be relatively low. The current value is 50% above book and has a P/E of 11.39. This level is around where the stock should be, and an investment recommendation at this time would be "hold."

Works Cited:

Areddy, J. & Galbraith, A. (2011). Ryanair trumpets airplanes from China. Wall Street Journal. Retrieved December 1, 2011 from http://online.wsj.com/article/SB10001424052970204262304577067951924584354.html

Financial Times. (2011). Bonds & rates. Financial Times. Retrieved December 1, 2011 from http://markets.ft.com/research/Markets/Bonds

FTSE (2007). FTSE all-share index 10-year performance (GBP total return). Retrieved December 1, 2011 from http://docs.google.com/viewer?a=v&q=cache:BaNQpNQ7lokJ:www.ftse.com/Indices/UK_Indices/Downloads/FTSE_All-Share_Index_Historical_Factsheet.pdf+FTSE+historical+return&hl=en&gl=us&pid=bl&srcid=ADGEESjGpTzDl4SpsTsCXgNX8MO2Iraw3WYv9h4ga1MtPTSq5hTBhDiT1hBzU0N_bmVjnEF4lRHTcNdM1d2u8t1cuokHy72uwB0mqtiFsa4NymfFz3Dwuiq5pRRq0Z5wktvFX1Cyz5bU&sig=AHIEtbRyche-12QJJYxGlLMAHZzI-QuXLA