Flying high

Croesus/The Investor's View: Oil at $100 (EUR 69) a barrel and markets in turmoil are not the headlines airline chiefs like to see.

Even if oil does not breach the $100 mark, it is clear that high oil prices are here to stay. Likewise, while the crisis in the credit and money markets seems to be beginning to come under control, central bankers and key industry players are signalling that it will be several more months before the storm has fully abated.

This is clearly a very challenging environment for airline companies and it is no surprise to find that many airline stocks have suffered price declines this year.

Among the European majors, the share prices of British Airways and Air France have each fallen by approximately 25 per cent, while low cost airline Air Berlin has endured a 27 per cent price decline.

However, a number of airline stocks - including Ryanair, Easyjet and Iberia - have enjoyed share price gains this year. In fact, in the face of the severe headwind of the rising oil price, the airline sector has performed relatively well and much better than the battered financial and construction sectors.

BA released interim results for the six months to September 30th and reported operating profits of £556 million (EUR 800 million). A key target of Willie Walsh, chief executive, is a 10 per cent operating profit margin and the company expressed confidence in reaching this target by March 2008.

Strict cost control is playing an important role in achieving the profitability goals. Current year profits will also be helped by some clever fuel hedging.

BA has hedged approximately 90 per cent of its fuel costs to end of March 2008 at an equivalent price a barrel of approximately $70. Despite this, its fuel bill is expected to rise by £100 million (EUR 144 million) and to exceed £2 billion for the first time, presenting a major ongoing challenge.

BA said commented that yields rose by half a percentnage point due to the strength in premium traffic. North American non-premium traffic remains soft although other non-premium routes are more encouraging.

Meanwhile, in the low-cost sector, Ryanair produced an impressive set of second- quarter (July-September) results. Net profit grew by 24 per cent to reach EUR 268.7 million for the period.

Strong growth in ancillary revenues was an important element in boosting turnover.

Ancillary revenue per passenger increased by 27 per cent, helped in part by excess baggage charges and priority booking fees. Passenger numbers grew by 21.5 per cent and net profit margins were maintained, despite a 22 per cent increase in capacity.

At an investor presentation on September 28th, Ryanair outlined its strategy to double profits between 2007 and 2012. Like BA, Ryanair has fuel hedges in place that cover about 90 per cent of its requirements to March 2008. However, beyond that, sustained high oil prices have the potential to constrain profit growth next year.

The response of the network airlines to high oil prices is to impose fuel surcharges on the cost of flights. Ryanair eschews such tactics, but this competitor response does open the way for Ryanair to edge up its average fare per passenger.

Like Ryanair, Aer Lingus has boosted its sales through strong growth in ancillary revenues due to checked baggage charges, travel insurance and seat pre-selection fees on short-haul routes. Industrial relations issues have cost money and are likely to continue to be a negative as the management strives to reduce the cost base.

Ryanair still offers by far the most attractive business model. Its unit costs are far below those of its nearest competitors and the company is well equipped to grow rapidly, and profitably, over the medium term.

Better growth prospects and a robust business model are, however, reflected in a premium rating with a 2007 price/earnings (p/e) ratio of 18. This compares with BA p/e ratio of 7.5 and the Aer Lingus rating of 13.6.

The more successful international low-cost peers also trade on high ratings. Southwest Airlines in the US trades on a p/e of 22 while EasyJet's p/e is 19. Despite the higher p/e, Ryanair continues to offer investors a more attractive investment proposition than most of its quoted competitors.