[RYAAY] LOW COST FLYWHEEL

(1,827 words) “One thing we have looked at is maybe putting a coin slot on the toilet door…Pay-per-pee.  If someone wanted to pay £5 to go to the toilet, I’d carry them myself.  I would wipe their bums for a fiver.”

  • Michael O’Leary, CEO of Ryanair

In a letter to one of GEICO’s officers dated July 22, 1976, Warren Buffett wrote:

“I have always been attracted to the low cost operator in any business and, when you can find a combination of (i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation. That situation prevailed twenty five years ago when I first became interested in the company, and it still prevails.”

One of the most compelling moats a company can possess is a set of self-reinforcing processes that continuously fosters lower unit costs. Interactive Brokers, for example, benefits from such a dynamic.  As I’ve previously noted, IBKR can charge its customers a fraction of the commission assessed by peers and still generate significantly higher profit margins because it: 1) spends far less of its revenue on advertising; 2) does not support physical branches or an army of customer service reps, and less appreciated but critically; 3) attracts trading volume that is itself endemic to continuously driving down execution costs, since the more trades the company executes, the more optimally it can route orders to low-cost venues, and better execution in turn, leads to more trading volume.

Ryanair benefits from a similar low-cost flywheel.

This story really begins with Herb Kelleher – the founder of Southwest Airlines, the company that Ryanair modeled itself after – who observed that the hub-and-spoke networks operated by legacy carriers, designed to maximize load factors, sub-optimally left aircraft stranded on the tarmac waiting for feeder traffic and baggage transfers.  Herb understood that to generate healthy profits along short point-to-point routes, he had to keep his planes off the ground and in the air for as long as possible while assiduously controlling costs, which informed an operating framework designed to hasten turnaround times: single-class, unassigned seating to expedite onboarding; a no-meals policy to obviate time-consuming clean-up; a single aircraft model (Boeing 737) to reduce crew training costs and enable speedier repairs and servicing; and at least at the start, concentrating on uncongested, secondary airports to enable rapid take-off and landing.

Michael O’Leary, profanity-oozing ass-kicker and Ryanair CEO since 1994, left Kelleher’s charm and decency on the Love Field tarmac but imported his operating model to Europe, stoking a relentless self-reinforcing moat entrenchment process that continues to this day.  Early in its corporate life, by targeting secondary airports desperate for traffic – Hahn, not Frankfurt; Brescia, not Verona; Lubeck, not Hamburg; Skavsta, not Stockholm – Ryanair obtained substantial landing fee discounts.  Stansted, for instance, agreed to charge Ryanair £1 per passenger vs. the official rate of £6 while Essex airport offered heavily discounted fees on new routes, laddering up to higher tariffs over 4-5 years as those routes matured and densified.  Ryanair recycled the cost savings into lower passenger fares, attracting fresh waves of traffic that were used to negotiate favorable landing fees at other secondary airports and receive discounts on aircraft orders from Boeing.

[When reading coherent business triumph narratives involving bold actors and crafty strategy, it’s easy to neglect the crucial role of luck.  Just to swiftly dispel the notion that Ryanair’s status as the largest and most profitable airline banner in Europe was inevitable, know that the company was on the brink of collapse in the late ’80s before Ireland’s persuasive Minister of Transport somehow convinced the Cabinet to break up Aer Lingus’ monopoly, yielding critical, life-saving routes to Ryanair.  At the time, O’Leary, who was handling finances for the troubled airline, actually recommended to Tony Ryan (the airline’s founder) that the whole cash-draining enterprise be shut down before striking what turned out to be an insanely profitable compensation package for himself, one which granted O’Leary a quarter of any profits above £2mn, a goal Ryan believed outside the realm of possible at the time (this deal has since been scrapped).  The Aer Lingus break-up was then followed by EU’s 1992 Open Skies treaty, which deregulated the European airline industry and allowed carriers to fly passengers between EU states.  I found this story and other interesting historical tidbits referenced in this post in the book Ryanair: The Full Story of the Controversial Low-Cost Airline written by Siobhan Creaton]

Complementing this feedback loop, a keen obsession with cost control and efficiency has taken root in policies and behaviors ranging from cringeworthy (charging the disabled for wheelchairs) to heroic (O’Leary heaving baggage onto planes during strikes) to downright petty (apparently and perhaps apocryphally, at one time Ryanair banned employees from charging their mobile phones during work hours, citing theft of company electricity amounting to 1.4 pence per charge), reinforcing an unrepentantly utilitarian attitude toward customer service: humane treatment for one compromises low costs for all.

This has all crescendo’ed to a cost structure today that no European competitor is even remotely positioned to rival.  Ryanair’s cost per passenger (excluding fuel) is just €27 vs. €40 for Wizz Air, the second lowest-cost airline.  Culturally stodgy full-service European incumbents like IAG, Air France, Lufthansa, and Air Berlin have average ex. fuel per passenger costs that run 4x higher than Ryanair’s.  Besides maybe Wizz Air, a low-cost carrier focused on Eastern European routes, no competitor can match the company’s €42 airfare and still make money.  This cost advantage will only widen as the company inks still more incentive deals with airports and takes delivery of Boeing 737 MAX aircraft, which come with 4% more seats and a 16% reduction in fuel costs per passenger.

And so, because engaging in a fare war with Ryanair is suicidal – as the failed low-cost initiatives of major incumbents like Virgin Express, BA Go, and KLM Buzz attest – Ryanair can profitably undercut competitors and steal their passengers, maximizing load factors while leveraging market share gains to secure increasingly advantaged landing fees and aircraft prices, with the capacity to incessantly reinvest the resulting savings into still lower passenger fares.  Over the last dozen years, this self-perpetuating process has spurred 14% annual growth in passenger volume, amplifying scale advantages that have allowed Ryanair to cost-effectively (EBIT/passenger has remained flat over this time) extend its reach beyond secondary airports.  Unable to compete with Ryanair’s prices, competitors have increasingly relinquished bases in Germany, Italy, Spain, and Belgium, compelling primary airports, which today represent just over half of all airports served by the company, to negotiate attractive volume deals with Ryanair.

[On public conference calls, O’Leary will frequently and explicitly highlight its cost advantage over peers, often goading competitors by name.  The confrontational posture is more than just an unvarnished reflection of O’Leary’s gracious personality; it signals to competitors that Ryanair stands credibly ready to take fares down to levels that would still allow Ryanair to generate profits while producing significant losses to them, i.e. “don’t even bother competing with us on price” (my words)].

Sometime in the late-90s, Ryanair placed an £800mn order for 25 planes with Boeing with the option to purchase 20 more for £650mn, a huge commitment for what was then a relatively unknown fledgling.  To test the company’s creditworthiness, Boeing rigorously stress tested the airline’s business model through computer-simulated declines in passenger traffic, fluctuating fuel costs, and exchange rates.  The result: Boeing could not find a single 3-month period in which Ryanair would not be profitable.

Boeing’s Director of Sales in the UK and Ireland remarked,

“The lowest we could do was break even….It is probably the most robust model we have encountered.”

This assessment would prove mostly prescient as Ryanair subsequently delivered positive operating profits each fiscal year up to today (“mostly,” because there were losses in some 3-month periods), generating among the highest returns on capital (averaging low-teens over the last 15 years) of all European airlines.  Under O’Leary’s guidance, management has acted as capable stewards of capital, opportunistically retiring 15% of the company’s share count over the last 5 years at attractive prices – with nearly 30% of that reduction taking place during the Brexit vote, when the company increased its share repurchase authorization to seize on the stock’s ~25% decline – all while maintaining a pristine balance sheet, which carries less than €600mn in net debt against €2bn in LTM EBITDA.  The stock trades at 16x trailing earnings with a long runway for growth as passenger volumes, per management’s guidance, expand by ~9%/year (about 2x the industry) from 119mn in FY17 to 200mn by FY24, and assuming flat fares, earnings should grow meaningfully faster than that on lower costs per passenger (as the more efficient MAX comes on line) and higher per-passenger ancillary revenue.

Since Ryanair announced that membership in myRyanair for all online bookings would be mandatory last November, membership has surged and is expected to reach 20mn by March 2017.  Besides the immediately obvious revenue and cost opportunities from upselling reserved and upgraded seats (which has prompted management to raise medium-term guidance on ancillary sales) and disintermediating costly OTA and metasearch traffic, there are significant advantages from directly interfacing with a huge customer base, like fostering loyalty through customized services and even, just maybe, scaling an in-house OTA, linking travelers to car rentals and hotel rooms.  Over the last decade, passenger fares haven’t really budged much at all; however, ancillary revenue per passenger has nearly doubled, from ~€8 to ~€15 per passenger, driving all of the per-passenger EBITDA growth over that period, and now that Ryanair has made myRyanair membership mandatory, its burgeoning captive audience should translate into still greater ancillary sales/passenger.

Brexit has prompted Ryanair to pivot away from the UK and concentrate its growth ambitions in continental Europe.  The UK represents about 2% of the company’s capacity and 3 out of its 1,800 routes, so it seems like a manageable risk, though who can fully handicap the destabilizing consequences of creeping populist/isolationist sentiment?  It’s a risk.  Still, pick a year, any year and you’ll find that there has almost always been a sound macro, political, or industry-specific reason not to invest in Ryanair stock: ATC strikes, terrorism, austerity measures, economic contraction, fuel shocks, low-cost competition from incumbents, low-cost competition from upstarts, foot and mouth disease, the Iraq War, Avian flu, Volcanic ash clouds.  Just as GEICO’s structural cost advantage remained intact despite the company’s reckless underwriting practices during the ‘70s, so has Ryanair’s persisted through these destabilizing exogenous events.  And besides, through it all, it turns out that for the right price folks still want to explore different cultures, get away during holidays, and visit loved ones in distant locations.  I suspect this will continue to be true over the next decade.

So if you’re a shareholder, the next time you find yourself on a Ryanair flight, as you recline comfortably squirm perpendicularly in your squeaky, navy blue seat, carapaced by overhead compartment doors littered with tacky revenue-generating ads, feel free to silently cheer through your discomfort.