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Ryanair reported second-quarter results on November 2, posting a strong operating profit. Although year-to-date operating margins have been solid, we expect increased pressure for the remainder of the fiscal year because of declining yields and seasonality. As such, we're maintaining our fair value estimate.

Revenue for the quarter decreased 4% from last year, primarily because of a 20% decline in average fares, partially offset by an 18% increase in passenger traffic. Although yields substantially fell from last year's levels, the airline's profitability for the quarter was bolstered by a 42% decline in fuel costs; the operating margin reached 30% from 19.6% last year.

Although Ryanair has been able to maintain its 88% load factor for the quarter, it's come as a result of the company's large price promotions on its fares. As such, we're projecting a near-20% yield decline for the year. Even though profitability has been solid for the first half of the airline's fiscal year, we expect profitability to be weakened during the second half, which tends to be negatively affected by seasonality. Nevertheless, the company is financially healthy and ended the quarter with more than EUR 2.5 billion in cash.

We expect the company to continue to increase its market share amid turbulent economic conditions because of the company's strong financial position, coupled with it's low-cost, low-fare structure.

Fair value estimate: EUR 2.70 │ Fair value uncertainty: Very high │ Economic moat: Narrow

Thesis (last updated 27-10-2009)

European airline Ryanair has built low costs into every aspect of its operations. The airline flies just one type of airplane, the Boeing 737, affording greater flexibility and savings on training and maintenance. The company flies its planes to second-tier airports where it has been able to save on fees, especially by negotiating with the local airport authority. For the most part, Ryanair will open service only to airports where it can maintain its industry-leading, 25-minute turnaround, which increases the utilisation of its airplanes. Ryanair also contains labour expenses by emphasising productivity-based pay. In contrast to most other airlines, where union contracts lock in pay regardless of actual hours in the cockpit, more than 40% of Ryanair pilots' total compensation is based on such variables as number of hours or sectors flown. Ryanair's flight attendants are compensated partially by commissions on the merchandise that they sell on the airplane during flight.

The company's industry-leading profitability is not only driven by low operating costs but also by ancillary, high-margin revenue. Ryanair's flight attendants are motivated to sell all kinds of products on each flight, including food and drinks, in-flight entertainment, calling cards, and even merchandise. Plus, Ryanair has leveraged the high traffic on its Web sites to promote rental cars and hotels. Ancillary activities such as these rose to about 20% of Ryanair's revenue last year from 15% the previous year, and enabled the firm to achieve an operating profit as oil prices peaked in 2008 versus losses for US-based low-cost carriers.

Moreover, due to continued high oil costs, management has shifted its focus toward recouping higher fuel expense through additional a la carte fees for checked baggage and other services. The firm has structured its fees to discourage excess baggage weight in the hope of saving on fuel consumption. Although strict attention to costs and new sources of ancillary revenues partially offset high oil prices in 2008, Ryanair now faces travel demand destruction caused by the global economic recession. However, Ryanair's dedication toward the lowest-priced airfare may serve the company well as consumer price sensitivity increases amid global economic uncertainty.

Valuation

Our fair value estimate for Ryanair is EUR 2.70. Our fair value uncertainty rating is very high because of global economic uncertainty as well as the large impact that oil prices have on the firm's results. In order to cope with recent record-high fuel costs, Ryanair pared back its schedule, cut airport and handling costs by moving to online check-in, and increased ancillary revenue with strict fees for checked baggage. Although these measures helped partially offset high fuel costs, we expect that operating margins will come under pressure amid a potential downturn in travel demand. Our operating margin assumption averages around 10% during our five-year discrete forecast period, well below the five-year historical average of 18%.

Risk

A return to high fuel prices would considerably hinder Ryanair's profitability. Furthermore, the threat of terrorist attacks or an escalation in international conflicts may decrease passenger volume. Because 35% of Ryanair's revenue is based in pounds, depreciation of that currency against the euro would hurt the company's top line. Additionally, unionisation would threaten Ryanair's profitability.

Strategy

Ryanair seeks to stimulate demand for air traffic by offering the lowest fares to points across Europe while maintaining the lowest-cost structure. To this end, the firm continually strives to achieve greater cost reductions and operating efficiencies. Management is aggressively expanding its route network while trying to increase ancillary revenue faster than scheduled passenger revenue.

Management & Stewardship

Michael O'Leary, Ryanair's dynamic CEO, has been the architect of Ryanair's low-cost strategy and has headed the most successful team to implement a Southwest Airlines model in the deregulated European markets. As a result of O'Leary's leadership, Ryanair's performance has outstripped that of all competitors in Europe and arguably Southwest itself. O'Leary has been outspoken against his critics who claim that the company has negotiated illegal concessions from airports and has denigrated air travel to the detriment of the customer. He views the airline industry as a pure commodity and has been unapologetic in charging customers fees for excess baggage and anything else nonessential. Although we believe that O'Leary has been instrumental in shaping the airline, we expect his largely handpicked executive management team to carry out the same mission once O'Leary departs. Executive compensation is consistent with that of similar airlines, and directors and officers own a combined 5% of outstanding shares. O'Leary owns about 4% of ordinary shares.

Profile

Ryanair operates the largest low-fare scheduled passenger airline in Europe, serving primarily short-haul, point-to-point routes. The firm has more than 30 base airports and serves more than 100 cities across 26 countries. The company employs more than 6,000 people and operates a fleet of more than 200 Boeing 737 jets.

Growth

Ryanair has achieved tremendous growth during the last five years. During that time period revenue growth has increased at an average rate of 23% and capacity (as measured in available seat miles) growth has increased at an average rate of 28%.

Profitability

Operating margins at Ryanair have been steadily declining because of the rise of oil prices and other low-cost competitors. As a result, we don't expect the firm to maintain the 20%-30% operating margins it boasted prior to fiscal 2009.

Financial Health

With EUR 2.5 billion in cash on its balance sheet, only around EUR 350 million of debt coming due during the next three years, and EBITDA consistently covering interest expense many times, we think Ryanair is financially sound.

Bulls Say

1. By only flying B737-800s, Ryanair should enjoy substantial cost savings from this unified fleet of next-generation, more efficient aircraft.

2. Even while maintaining the lowest-cost structure, Ryanair still outperforms all other European airlines in terms of on-time arrivals, fewest cancellations, and fewest lost bags.

3. None of the firm's employee groups is represented by a union, allowing the airline greater flexibility.

4. Ancillary activities like partnership deals for rental cars and hotels, on-board merchandise sales, branded credit cards, and other fee services account for 20% of revenue and directly boost margins.

Bears Say

1. Ryanair's outstanding profitability might generate greater labour demands for compensation and benefits.

2. New European Union rules dictate that airlines must compensate passengers in the event of overbooked or canceled flights, which could raise the cost of doing business.

3. As Ryanair's pilots and crew accumulate tenure, compensation will likely become more costly for the airline.

Michael Pierson is a Morningstar stock analyst. Morningstar's editorial policies prohibit analysts from owning stocks they cover.

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Financial Information for Ryanair Holdings PLC