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a mine of invaluable information for the private investor.
Selecting shares without its help is like trying to
clap with one hand tied behind your back.
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UK
Shares
Airline
sector view
Historically,
airlines have been a rotten investment. It is a capital-intensive
industry (aeroplanes are an expensive purchase) and fixed
costs (the fuel needed to run a plane) are high. That tends
to mean that the companies involved have a high degree of
financial gearing (large borrowings) and also operational
gearing (if a plane is 85 per cent full, it breaks even; if
it’s 100 per cent full it makes a big profit; but if
it’s only 70 per cent full, the flight is hugely loss-making).
The situation has historically been made even worse by the
existence of heavily subsidised state-backed airlines in Europe
although this is now easing.
A few years ago the low-cost airlines promised to revolutionise
the industry. Companies such as RyanAir and EasyJet cut out
all the frills, flew to cheap out-of-town airports and sweated
their assets (the planes) far more extensively than the flagship
airlines. The City liked this story and the budget carriers
found it easy to raise cash to expand. The problem –
as any economist will tell you – is that if there is
no effective barrier to entry to a sector (and there seems
little barrier to entry in the budget airline world) extra
high returns will quickly suck in fresh competition. And that
is precisely what has happened.
With extra planes in the skies, the only way airlines can
maintain the high capacity that they need to be profitable
(operational gearing) is by cutting prices. This is great
news for consumers but awful news for shareholders. Already
one weaker budget airline has bitten the dust and others will
follow. The established and large budget carriers will almost
certainly survive, but with fuel costs increasing sharply,
the short-term effect on margins is clear.
As such this is a sector with minimal earnings visibility
on a 12-month view. If you are planning a summer holiday right
now, you can celebrate what is happening. If you are short
of airline stocks plan a double celebration. This is not a
sector that will be reporting bumper numbers for 2004.
Airline share view
EasyJet warned in early June that its current
year profits would be un-likely to be much more than the £55
million it racked up last year.
For a stock on a growth rating – and which had been
forecast to make £84 million – that has obvious
consequences. The two problems are the price of kerosene (55
per cent of EasyJet’s fuel needs are hedged but the
rest are exposed to market vagaries) and the intense competition
for volume amongst the budget airlines, which is forcing prices
down.
Based on the new September 2005 numbers (earnings of around
10p) the shares, at 169p, still trade on a current year price/earnings
ratio of 17. The problem is that whatever EasyJet says about
being confident of beating 2003’s numbers, it really
has no idea about forward kerosene prices or just quite how
much of a bloodbath the competition among the budget airlines
will become. To accord a growth rating to a company with such
low earnings’ visibility seems mighty generous.
EasyJet’s big rival is the Irish budget airline RyanAir,
run by the outspoken Michael O’Leary. He is a man who
knows how to grab headlines, even favourable ones.
But whatever the charms of O’Leary, he acknowledges
that he is in essentially the same boat as EasyJet. This year
will be awful but as long as his company survives, next year
should be better. It all depends how long the newer entrants
to the aviation world choose to stay in the game.
At ™4.656 RyanAir trades on a current year price/earnings
ratio of around 15, which for a company projecting minimal
earnings growth for the current year is, again, very generous
indeed.
And, as is the case for its rival, there really is very little
guarantee that those forecasts will be met – earnings
visibility is minimal. A forward p/e of 15 could – in
reality – quite easily be a forward p/e of 20. You buy
such stocks only on a leap of faith. A £29 return ticket
to Barcelona looks a much better investment.
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