Ryanair’s Changing Altitude

On Feb. 4, Michael O’Leary, chief executive of Ryanair (RYAAY), Europe’s largest airline by number of passengers, warned that its profits could be cut by up to half next year due to a “perfect storm” of rising oil prices, weakening consumer demand, and higher airport charges. Shares plunged more than 15% in Dublin trading on the news before bouncing back to end the day down 2.2%.

Chalk up the share price recovery to O’Leary’s eternal optimism. Even though he predicts Europe’s aviation industry is flying headlong into a recession, the voluble executive sees opportunity for Ryanair. “We’d welcome a good, deep, and bloody recession because it will lead to significantly lower airfares and that will be good for Ryanair’s business model,” he says. “We’ll emerge stronger and with fewer competitors.”

O’Leary’s good news/bad news predictions came as the Dublin carrier reported a decline in quarterly profits, for only the second time since O’Leary took the helm in 1993. For the quarter ended Dec. 31, 2007, Ryanair’s aftertax profits plummeted 27%, to $52 million, less than the $65 million that most analysts predicted. Yet despite a rough patch for Ryanair and other discounters [BusinessWeek, 1/9/08], O’Leary reckons that the company is still on track to post net profit growth of 17.5% for the fiscal year ending in March.

Industry Shakeout Likely With little visibility beyond next March, do Ryanair’s gloomy predictions spell the end of the boom times for Europe’s discount airlines? Far from it. Sure, there has been a surge in rivals. Ryanair’s success has spawned a slew of imitators such as Vueling Airlines (VULG.F) and Iberia-owned (IBL.F) Clickair in Spain, Germany’s Air Berlin (AB1.DE), and Hungary’s Wizz Air.

What’s more, despite intense competition, short-haul carriers have added capacity aggressively; Ryanair alone added 6 new bases and 194 routes in the past year. All told, the combination of extra capacity and an economic slowdown that could curb consumer spending increases the likelihood of an industry shakeout, as many of the smaller, newer players with higher operating margins are either driven out of business or acquired.

But analysts reckon Ryanair is better positioned than its competitors. The global aviation industry is flying into the worst turbulence in the past six years, but the Irish airline has achieved enough scale to weather the storm. Indeed, its strategy is to expand its way out of recession by slashing fares, stimulating demand, and opening new routes. Ryanair, which now carries more than 50 million passengers a year, plans to double its fleet, passengers, and profits by 2012. “Ryanair has the strongest business model of any European airline,” Citigroup (C) says in a Feb. 4 report, citing the carrier’s lower-cost advantage, growth prospects, and strong balance sheet.

Extra Charges Keep Margins High Boosting revenues while slashing fares may seem counterintuitive. But Ryanair’s low costs and its penchant for charging for everything [BusinessWeek, 11/16/06] from using the check-in desk to stowing your bag in the hold have kept margins high. The airline’s $65 average airfare is 50% less than the average fare of its rival Britain’s Easyjet (EZJ.L), but its net margins, at 18%, are the highest of any European airline — even including the big long-haul carriers with their lucrative transatlantic routes and business-class customers.

This is Ryanair’s big advantage, and one that is likely to carry it through the downturn. For budget airlines with the lowest operating costs, the expected economic downturn may open up major opportunities. As many of the flag carriers, from British Airways (BAY.L) to Lufthansa (LHAG.DE), cut back on short-haul flights to focus on transatlantic and business traffic, well-funded players such as Ryanair and Easyjet can win market share.

Despite the rapid growth of low-cost airlines, argues Citigroup, Continental Europe is still relatively underserved. The bank predicts Ryanair will be able to continue boosting revenues by around 20% per year. O’Leary agrees: “We are still growing like gangbusters. There is an almost insatiable demand for low-fare air travel.”

Not Safe from Higher Oil Prices Ryanair’s low overhead also means it can make money on routes that many of Europe’s biggest domestic carriers are abandoning. O’Leary says that two years ago big regional airports such as Belfast City and Birmingham had no interest in cutting deals with Ryanair. After all, British Airways was willing to pay substantially more to use the airports. But since BA decided to cut back on short-haul flights, these airports “are coming to us, saying, ‘please open a base here,’ ” O’Leary says. After starting up in Belfast at the end of last year, Ryanair announced it will open its 25th base in Europe at Birmingham in April, eventually offering 20 new routes to Europe.

So what could clip Ryanair’s wings? Oil. Hedging in the energy markets locked in Ryanair’s oil price at $65 a barrel this fiscal year, but the airline is largely unprotected for next year. Fuel accounts for more than one-third of the company’s operating costs, and each $1 movement in oil above $65 adds $21 million in annual costs. Ryanair will begin hedging again if crude falls below $80 a barrel, O’Leary says. The sky-high cost of fuel is one reason that O’Leary welcomes a recession. “Finally, it will give us a break on oil prices,” he says.