Ryanair Holdings PLC (RYAAY)
The Costco of airlines
In 2007, Warren Buffett wrote in a letter to Berkshire Hathaway investors that “if a far-sighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” Buffett has famously been skeptical about investing in airlines for much of his career. In fact, he once quipped that "the worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money." Historically, airlines fit this description due to their high capital requirements, low-profit margins, and susceptibility to external factors like fuel prices and competition.
Despite his longstanding skepticism, Buffett surprised many in the investing world when Berkshire Hathaway started investing in major U.S. airlines in 2016. Berkshire purchased significant stakes in American Airlines, Delta Air Lines, United Airlines, and Southwest Airlines. This move marked a significant departure from Buffett's previous stance on the industry.
In 2020, amid the COVID-19 pandemic, Berkshire Hathaway sold off large portions of its holdings in the airline industry. The pandemic severely impacted air travel demand, leading to massive losses for airlines and a steep decline in their stock prices. Buffett cited the uncertainty surrounding the future of air travel and the industry's long-term prospects as reasons for divesting Berkshire's airline holdings.
Soon after, as vaccination rates increased and travel restrictions eased in many regions, travel demand recovered. However, the initial rise in stock prices was tempered by the fact that the re-opening was a a complex and gradual process, influenced by various factors including vaccination rates, government policies, and travel restrictions.
Was Buffett right in his initial thesis? We don’t know but we do admire his willingness to change according to the facts. Despite being skeptical of airlines, he followed them and bought positions in them when he saw that together – Delta Air Lines, American Airlines, United Airlines, and Southwest Airlines – controlled 90% of all U.S. domestic air traffic. This typically means pricing power and it was the same setup that lead to the increase in profitability of the North American rail sector.
In our analysis of EPAM, we talked about Buffett's comments regarding the enduring nature of consulting businesses, noting that Berkshire companies seldom change their IT consultants. However, we contend that he could have made a more advantageous choice by investing in Accenture instead of IBM. Similarly, we suggest that Buffett might have found greater success by considering Ryanair, rather than venturing into the turbulent waters of the US airline industry.
Ryanair (RYA) is one of the largest airlines in the world. It has successfully replicated the ultra-low-cost carrier model initially created by Herb Kelleher in the US. The Company is based in Ireland and has a NASDAQ-listed ADR, RYAAY (5 shares of ADR = 1 ordinary share). In fact, we will argue that RYA has taken the Herb Kelleher model as seen by the average fair below:
The Ryanair business is simple to understand, but how it operates and executes this strategy in every part of its business model is incredibly rare.
“The airline industry is full of bullshitters, liars and drunks. We excel at all three in Ireland.”
-Michael O'Leary
Ryanair operates a low-cost carrier model. Each quarter, they re-emphasize their focus on having the lowest fares/costs relative to EU peers. The best analogy for the business model isn’t another transportation or airline business; instead, it is other scaled-shared economy business models, such as Costco and Amazon, which have effectively applied this strategy to retailing. Jeff Bezos’ 2005 Annual Letter to Shareholders explains Michael O’Leary’s basic approach to growing the business.
“As our shareholders know, we have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible. This is an example of a very important decision that cannot be made in a math-based way. In fact, when we lower prices, we go against the math that we can do, which always says that the smart move is to raise prices. We have significant data related to price elasticity. With fair accuracy, we can predict that a price reduction of a certain percentage will result in an increase in units sold of a certain percentage. With rare exceptions, the volume increase in the short-term is never enough to pay for the price decease. However, our quantitative understanding of elasticity is short-term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or ten years. Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long-term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com.”
-Jeff Bezos (2005 Shareholder Letter)
This simple approach, which has effectively always stayed the same, has led to tremendous growth at the corporate level. Passengers carried have grown at an 18% CAGR since 1995. Ryan initially mimicked its business model after Southwest (LUV), which performed very well after deregulation in the US. Still, LUV’s strategy drifted over time to focus on higher revenue routes and yields as shown below in Exhibit W, Ryanair did not invent the low-cost airline carrier model, but they have implemented it perfectly in Europe.
Ryanair is a successful business by many measures and has a long track record of growth, high returns on invested capital, and growing market share. The ability to do this in a commodity-like industry is scarce. Most people inevitably look at companies with these financial characteristics and think they have missed the opportunity. We don’t think that’s the case – so while the future drivers might be different from the past, we think there is still a strong possibility for them to generate attractive returns for shareholders today.
RYA is headquartered in Ireland, but most of its routes are centered around the UK, Spain and Italy. The route exposure is skewed mainly to Western European countries but RYA is increasingly expanding in Eastern & Central Europe.
The company’s relentless application of the scale-economies-shared model has created tremendous value for all customers and shareholders. In our opinion, the only major stakeholder their expansion has hurt has been incumbent competitors, who have operated inefficient, higher-cost, and higher-priced routes for far too long.
We see a substantially improved competitive environment going forward as a result of the pandemic. Further, since 2019, over 35 airlines with operations throughout Europe entered into bankruptcy, and Ryanair went from the third-largest airline to the biggest in 2023. One of its key LCC competitors, Wizz Air, is facing challenges tied to its engine exposure (Pratt & Whitney GTF); this might create an environment of better-than-expected yields over the next three years (as we observed in the North American rail sector).
Importantly, the company’s capital allocation activities are expected to shift. In the past, most cash flow has been recycled into additional fleet growth and the rare M&A deal. We would not be surprised to see substantial cash returns to shareholders from now on while still driving positive growth in passengers carried (and capacity additions).
Over the past 12 months, RYA shares have rallied on the strength of consumer spending, employment levels, and a bias on spending on services instead of goods. Despite the move in the stock, we still think the stock can provide attractive returns in the future. A widely underappreciated dynamic will be how much fare pricing could increase as the industry structure matures into a more consolidated state like US markets.
RYA trades at a forward P/E of 9.3x and an EV/FCF Yield of ~11.6% on FY25 estimates - both below historical averages. The company’s healthy balance sheet and FCF generation of >2.5b should allow it to continue executing its growth strategy and increasingly return capital to shareholders as reinvestment needs moderate. Unlike many airlines that eventually drift away from a focus on the LCC model, RYA has been remarkably consistent in its approach. Michael O’Leary has successfully led the company for over 15 years and positioned it well for an attractive “end state” where pricing power might be higher than market participants believe.
In this report, we will review the significant pillars of the business model, review the profit pools of the aviation industry, and talk about risks and valuation. Importantly, we will expand on why airlines are such a horrible business and why Ryan Air is an exception.
Business Overview
Ryanair Holdings is a low-cost airline focused on point-to-point routes, mainly in Europe. The company operates five wholly-owned brands, including Buzz, Lauda, Malta Air, Ryanair DAC and Ryanair UK. Each brand has an Airline Operator Certificate (AOC), which allows them to operate commercial aircraft in the respective country. Ryanair’s business operations are focused only on short-haul travel and related products (i.e. baggage, travel insurance, accommodations bookings, etc). This contrasts with legacy carriers operating various activities, including long-haul travel, cargo shipments, and bundled holiday offerings. Below in Exhibit A, we provide an overview of the estimated fleet size of each brand as of early 2024 and fleet ages.
To execute on this strategy, RYA does a few things: