‘Ryanair and the importance of high ROE for growth and dividends’

Warren Buffett once quipped that the way to become a millionaire was to “start as a billionaire and buy an airline”, but our experience of investing in Ryanair, Europe’s leading low-cost airline has been somewhat different. In fact Ryanair is an excellent example of how a company with a superior business model can generate consistent compound earnings growth in a difficult industry environment. And given how few industries are currently booming, the success of the Ryanair may offer some useful insights into investing in the stock market as a whole.

For us, Ryanair’s superior unleveraged ROE (return on equity^#), currently 17%¹, is crucial to the success of its business model. Its high profit margins, derived from its significantly lower cost base, are the most obvious starting point in dissecting this financial ratio.  Excluding fuel costs, Ryanair’s average cost per passenger is just €27. This compared with other leading low-cost airlines such as Easyjet and Southwest (in the US) of €46 and €74 respectively². This comes from a more productive labour force (around half of their flight crew and staff are flexible contract workers) lower airport and baggage handling charges. The average age of its aircraft fleet at just 4 years gives it a significant fuel efficiency and maintenance cost advantage (the average flag European airline has a 10 year old fleet). This exceedingly low cost base allows Ryanair to offer the cheapest tickets in European aviation (on average 37% below Easyjet)².

Less obvious, but essential to its ROE superiority, is Ryanair’s superior asset turn. This stems from use of less busy lower cost airports with faster turn-around times (typically 25 minutes) helped by not encouraging passengers to check in-luggage or indeed assigning them seats. Ryanair also has higher seat densities, managing to fit more seats onto the same planes than competitors (was it kidding about charging for standing only?) and has higher than average industry load factors. In short, by turning short-haul leisure air travel into something akin to bus travel, Ryanair is able to sweat its assets better, meaning that it is less capital intensive and more free-cash flow generative. With a strong balance sheet (the company owns most of its own planes and is currently debt free³) Ryanair has been able to grow earnings and return €1.5bn in special dividends (and buy-backs) to shareholders over the last five years².

It is often assumed that companies face a binary choice between investing in their business for growth by increasing capital expenditure or paying out profits to shareholders as dividends. This is not the case for companies with high ROE, or more specifically it is a false choice for companies that have an ROE in excess of their growth rate. Take 2 stocks: both will generate 10% annual profit growth over the next 10 years; both currently trade at a P/E of 15x 2012 earnings (6x 2022); and in fact both will generate an equal amount of economic value added over the next decade.

So why would I prefer to invest Stock A? Because its ROE at 13% is in excess of its growth rate of 10% the stock is free cash-flow generative to the tune of 300bps of its book value per annum, allowing it to both grow and pay-out dividends. Stock B, by contrast, with half of the ROE (6.5%) but the same growth rate of 10% has an annual cash-deficit of 350bps of book value which must be raised externally every year (in capricious capital markets) in order to sustain the company’s growth ambitions⁴. High ROE is therefore as crucial to the dividend income investor as it is to the growth investor.

So how should Ryanair’s investors view its announcement yesterday of a mega plane order for 175 Boeing 737-800 aircraft at an official “list” price of $15bn compared to its current fleet of 305 planes and its current market capitalisation of $12bn?⁵ For growth investors the aircraft order will allow Ryanair to sustain 5% annual capacity growth over the next 6 years, taking annual passenger capacity from 80m to 100m, thus accelerating its likely annual profit growth rate. But dividend income investors should not despair: after 105 old planes are disposed of and considering significant discounts to Boeing “list” prices, Ryanair’s annual development capital expenditure is likely to peak at just over €1bn in 2017, meaning that the company is likely to still generate over €1bn of free-cashflow per annum every year and accumulate a net cash position in excess of €1bn as early as 2015⁶. So even accelerated growth prospects at Ryanair need not necessarily come at the expense of future dividends. In a macro environment of low growth and scarcity of yield, stocks like Ryanair combining attractive growth are in our opinion uncommonly attractive.

Barry Norris
Founding Partner & Fund Manager
20th March 2013