MASTER IN FINANCE
THIS REPORT WAS PREPARED EXCLUSIVELY FOR ACADEMIC PURPOSES BY MARCELA ALBERTO &MINH HOANG, A MASTER IN
FINANCE STUDENT OF THE NOVA SCHOOL OF BUSINESS AND ECONOMICS.THE REPORT WAS SUPERVISED BY A NOVA SBE FACULTY ▪ We initiate coverage of EasyJet (EZJ) with a BUY
recommendation and a FY19 Price Target of £13.34.
▪ Revenue per ASK is expected to be reduced by 2% in 2019. This considers a series of positive events in 2018 including the bankruptcy of Monarch and Ryanair’s winter cancellations, all of which are one-off events and thus unlikely to occur again. ▪ Traffic demand will continue to outperform its market, at 9%
and 8% in 2019 and 2020, since Brexit will only start to have an impact from 2021 onwards. The higher-than-average growth reflects easyJet’s value proposition from its primary airport network and potential gains resulting from the bankruptcy of other airlines operating in the same market. ▪ Ex-fuel cost per ASK will drop by 0.22%, delivering an
operating margin of 5.38% as opposed to 5.12% in 2018. This is driven by efficiency gains from the new fleet and by the recent appointment of DHL as the new handler for the ground operations at Gatwick, Bristol and Manchester airports.
▪ A strong balance sheet with a credit rating of Baa1/BBB+ and a net cash position of £396 million. This allows easyJet to continue to operate despite the cut-throat competition, where competitors are actively reducing fares to gain a bigger market share.
▪ DCF valuation method with a WACC of 5.35% produced an estimated price of £13.34 in 2019. This represents a total upside of 23% of which 20% from expected capital gain and 3% from cash gain.
Company description
Founded in 1985 by Stelios Haji-Ioannou, easyJet is a British low-cost carrier based in London Luton. The company is Top 5 of the European airline market in terms of passenger volume, carrying 88 million passengers and flying across 156 airports in Europe.
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Take-Off to New Opportunities
Temporary turbulence, Clear Skies Ahead
Recommendation: BUY
Vs Previous Recommendation -
Price Target FY19: 13.34 £
Vs Previous Price Target -
Price (as of 4-Jan-19) 11.11 £
Source: Bloomberg 52-week range (£) 10.30 -18.08 Market Cap (£m) 4,373.47 Outstanding Shares (m) 397.208 Source: Bloomberg Source: Bloomberg
(Values in £ millions) 2017 2018E 2019F
Revenues 5047 5822 6112 EBITDAR 709 882 783 EBITDAR margins (%) 14% 15% 13% Operating Costs 3154 3322 3460 EBIT 404 512 365 EBIT Margin (%) 8.0% 8.8% 6.0% Net Profit 305 404 277 ROIC (%) 15.22 19.91 8.56
EASYJET PLC COMPANY REPORT
Table of Contents
EXECUTIVE SUMMARY ... 3
COMPANY OVERVIEW ... 4
COMPANY DESCRIPTION ... 4SHAREHOLDER STRUCTURE AND DIVIDEND POLICY ... 5
MANAGEMENT TEAM ... 5
MACROECONOMICS ... 5
GDP ... 5 FUEL COSTS ... 6 BREXIT ... 6 ▪ Impact ... 7 ▪ Revenue ... 7 ▪ Cost ... 8EUROPEAN AIRLINE INDUSTRY ... 8
STRUCTURAL CHANGES ... 8
FURTHER MARKET CONSOLIDATION ... 9
PARTNERSHIP BETWEEN LCCS AND LONG-HAUL AIRLINES ... 10
PAST PERFORMANCE & COMPETITIVE ANALYSIS ...10
PAST PERFORMANCE ... 10
COMPETITIVE ANALYSIS ... 12
KEY VALUE DRIVERS ...13
REVENUE ... 13 COSTS ... 13
FORECAST ...14
INCOME STATEMENT ... 14 BALANCE SHEET ... 20VALUATION ...22
DISCOUNTED CASH FLOW ... 22
▪ WACC ... 22
▪ Growth rate ... 23
ENTERPRISE VALUE,EQUITY VALUE AND TARGET PRICE ... 23
MULTIPLES ... 24
SENSITIVITY ANALYSIS ...24
SCENARIO ANALYSIS ...25
ANNEXES ...27
INCOME STATEMENT &BALANCE SHEET ... 27
CASH FLOW MAP ... 28
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Executive summary
easyJet has been affected by the market´s general negative outlook towards the European short-haul aviation sector. Investors’ concerns have stemmed mainly from the uncertainty surrounding Brexit, rising oil prices and the consecutive collapse of several airlines. Given the airline’s performance in FY2018 and its growth potential, we think easyJet is undervalued and therefore recommend a BUY. Despite the cut-throat competition, in 2018, easyJet’s capacity grew by 9.4%, compared with 2.8% of its market, while reaching a record load factor of 92.9%. We expect demand to grow at 9%, and headline earnings to reach £238 million in 2019.
We propose the following explanations for easyJet’s positive outlook:
Brexit: We recommend a BUY in both the case of a Hard Brexit scenario (8%
decrease in demand) as well as a Soft Brexit one (6% decrease in demand). With 16% business travelers and 55% of current capacity coming from outside of the UK, Brexit’s impact will be alleviated. Furthermore, the 21-month transition period will delay Brexit’s effect.
Sustainable competitive advantage: Out of easyJet current capacity, 89% is at
slot-constrained airports and 99% travels through airports where it has a number one or number two position of market share. This allows easyJet to offer routes between primary airports with high frequency, hence its 16.8% revenue growth and 17% increase in the number of business travelers in 2018. Given that, we do not think its competitors can challenge its position in the short term.
Efficiency gain from fleet up-gauge: By 2021, new generation aircraft
(A320neo and A321neo) will account for 30% of the easyJet fleet. With a higher seat per aircraft, they deliver 11-20% cost savings per seat. Given that the oil price is increasing, this represents a significant competitive advantage to easyJet.
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Company overview
Company description
easyJet is a Luton-based low-cost airline carried founded in 1995 by Stelios Haji-Ioannou. With a network of slot-constrained primary airports, easyJet has been able to capture market share from legacy airlines over the past decades. It is a top 5 player in terms of passenger volume, with 88.5 million passengers in 2018. The airline offers point-to-point flights between primary airports across 979 routes in 32 countries as of 2018. Out of the 156 airports where it is operating, it holds number 1 or number 2 position based on short-haul capacity in 51 airports. easyJet focuses mainly on Europe’s largest markets by GDP, including the United Kingdom (UK), France, Italy, Switzerland, Germany, Netherlands, Spain and Portugal. Even though the UK has the highest share in terms of capacity, the airline has spread its presence in countries such as Germany (50.9% capacity growth) through the Air Berlin acquisition, as well as Italy (10.4% capacity growth) and Switzerland (8.6% capacity growth).
The airline has recently undergone a fleet up-gauging, in which previous model aircraft are being replaced by A320 and new aircraft generation of A320neo/A321neo. The new aircraft are expected to deliver a cost per seat saving of 11% to 20% thanks to its higher seat numbers. As of 2018, the company’s fleet comprises 315 aircraft, 70% of which are owned by easyJet.
Strategy
easyJet differentiates itself from other European short-haul airlines by offering point-to-point flights between primary airports with high frequencies at an affordable price. This particularly appeals to business travelers, who have the need to travel within the peak hours, and time-conscious travelers, who would save time getting to the city from primary airports.
With cheaper ticket fees, easyJet was able to capture market shares from legacy airlines and charter carriers. This has been possible thanks to easyJet’s low cost base, which was obtained through cutting inflight amenities, such as food and drinks, buying aircraft in bulk for bigger discounts, and reducing seat density. Nevertheless, LCCs are expanding their networks to major airports and are emerging as easyJet’s competitors1. For that reason, we believe that both LCCs
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and legacy airports are the competitors of easyJet and will be used as points of comparison throughout the paper.
Shareholder structure and Dividend policy
easyJet is listed on the London Stock Exchange and is part of the FTSE 100 Index. The shareholder structure is reflected on the Figure 1 and hasn't experienced significant shifts in recent years.
Since 2011 easyJet has been paying a dividend ratio of 33.3%, rising to 40% in 2014. Currently, the payout policy is 50% with a dividend of 58.6 pence per share in 2018. This represents an increase of 43.3% compared with FY2017. We see this as positive for investors since the payout ratio is above the industry average of 23%2.
Management Team
Johan Lundgren was appointed as the new Chief Executive in November of 2017. Under the new management, easyJet is pursuing three key initiatives: holidays, business customers and loyalty program. Given Johan’s experience at the tour operator for TUI, it is unsurprising that he is seeking to invigorate easyJet’s offerings in hotels and holidays3. Even though it will be difficult to get
access to the hotel market during peak periods, we believe that Johan’s knowledge in this area could bring easyJet another revenue stream in the highly competitive landscape short-haul travel sector.
Macroeconomics
GDP
Looking at Figure 2, GDP growth is positively correlated with Revenue Per Kilometer (RPK) growth. In fact, RPK and global GDP growth have followed a median multiplier of 2.1 since 19914. easyJet’s main market has been growing
steadily, with a GDP growth rate above 2% in 2018. Netherlands is the fastest growing country with a 5% growth rate, and Italy being the slowest with a 2.5% growth rate.
2 Source: Reuters 3Reuters News(2018)
4 IATA (2017) Air passenger market analysis
Figure 1: Shareholder Structure Figure 2: RPK growth vs GDP growth Source: Bloomberg Source: IATA
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Fuel costs
Fuel is an important cost item in the airline industry, which accounts for approximately 25% of overall costs5. Unlike other industries, the airline sector is
highly dependent on fuel and will not have an alternative to jet fuel in short-term. In 2020, the International Maritime Organization (IMO) will enforce a new limit of 0.50% global Sulphur cap for fuels, as opposed to the current limit level of 3.50% 6in an attempt to reduce emissions (IMO 2020) which would generate an
oversupply of high sulfur oil (3.5%) and demand for IMO-compliant products (0.5%) which will put pressure on the refining industry to produce substantially more compliant oil products, pushing crude oil prices upwards and as consequence cause airlines fuel costs to rise, as it can be seen in Figure 4. In addition to IMO 2020, oil prices have showed a rising trend since the beginning of this year. Even though oil price dropped back to $72 per barrel the end of November, average price has been fluctuating from $80 to $90, and almost reached $100 in October. Higher oil price generally results in a lower operating margin, as can be seen in Figure 5, and hence, further squeezes airlines profits. We expect airlines will be facing a dilemma of whether to raise the ticket fares or losing market share to other airlines offering competitive fees.
For easyJet, impact of fuel price can be alleviated with the new fleet up-gauging. New aircraft have higher seat number, and therefore, delivery a cost saving per seat of 11% to 20%, depending on the aircraft model.
Brexit
Following the referendum on 23rd June 2016, most UK citizens decided to leave
the European Union (EU). The departure of the UK from the EU (Brexit) has a wide-spread impact on several industries, especially the aviation sector.
Following Brexit result, the global airline sector experienced the biggest drop in share price of 25%7, with listed UK-based airlines down by approximately 33%. In
fact, easyJet was among the biggest losers on FTSE 100. Its share price fell by 33%, from 1,533p on the day of the referendum to 1,020p the following days. To explain the significant impact of Brexit on airlines, it is important to note that airlines sector is regulated by EU agencies like ECCA 8and EASA9. The access
to 44 countries and markets, such as US and Canada, is also secured by EU law.
5 Statistic Portal -Fuel costs of airlines as percentage of expenditure 6 Shell : IMO 2020
7 Change in share price between 28 May and 28 June 2016: KPMG (2016) Brexit: Implications for airlines 8 European Common Aviation Area - Single market for aviation within 36 nations
9 European Aviation Safety Agency - Managing safety standards within 32 nations Figure 3:
GDP Growth of easyJet Main Markets
Source: OECD
Figure 4: Jet Fuel Price Evolution
Source: Bloomberg
Figure 5:
Airline Worldwide Operating Margins vs Changes in Brent Crude Oil (%)
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Following the Withdrawal Agreement in November 201810, there will be a
transition period of 21 months to assist individuals and corporations adapt to the changes. During the transition period, the UK will still be treated as a member state, with the exception of participation rights within EU organizations. Until 2021, airlines can still transport passengers from the UK to the EU.
▪ Impact
To prepare for Brexit, easyJet has set up an Austrian subsidiary to reserve to the flying right within EU. It also converted UK pilot license into Austrian licenses. Even so, the airline will still be affected by macroeconomic factors, namely GDP growth and exchange rate. According to IATA, the pound is estimated to be 10-15% weaker than it would otherwise have been without Brexit. UK GDP growth rate also reduces 2.5-3.5% compared with the “no Brexit” scenario.
We expect there will be two main outcomes namely Soft Brexit (light shock), Hard Brexit (severe shock), with the latter being less likely. Soft Brexit is used to refer the agreement that keeps UK and EU closely aligned to minimize disruption in trade and in business. A typical example would be Norway, which is a non-EU country but is still allowed to operate within EU Single Market. In contrast, Hard Brexit refers to the UK escaping the EU regulations and tariffs, so that it can create its own customs rules. In this scenario, UK will leave both the EU single market and the customs union.11
We consider soft Brexit as our base case and will further develop a scenario analysis covering Hard Brexit.
▪ Revenue
As mentioned earlier, passenger demand growth closely follows the trend of GDP growth rate. Due to economic contraction from Brexit, UK air passenger volumes are estimated to be 3-5% lower12. With a lower disposable income, UK citizens
will be likely to spend less on travelling. In specific, the income elasticity of demand for air travel in developed markets is around 1.6. Let us also explore the price elasticity between business travelers and leisure travelers13. Overall in
short-haul flights, leisure travelers are more sensitive (1.5) to changes in prices than business travelers (0.7), thus the PPP would mostly affect leisure passengers. As such, we do not think Brexit will have a significant impact on demand of business travelers, which account for 16% of easyJet’s customers.
10 European Commission (2018) Brexit Negotiations: “What is in the Withdrawal Agreement” 11The Economist (2018) – How soft Brexit differs from hard Brexit
12 IATA- The impact of Brexit on UK air Transport 13 IATA- Air travel demand
Figure 6:
easyJet share price drop
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Finally, we do not see demand for intra-EU flights to be greatly impacted by Brexit as GDP growth rate of European Member States will suffer great losses compared to the UK.
▪ Cost
In the airlines sector, key cost items such as Fuel Expenses, Maintenance and Overhaul costs are incurred in US dollars. Given that these items represent 40% of total operating costs, easyJet’s cost base at reported currency will increase due to the weaker pound.
Furthermore, payments for operating leases and new aircraft are also made in US dollars terms. Hence, if the pound’s decline continues, the unit cost of UK airlines will be less competitive than airlines with less exposure to the UK.
European Airline Industry
Structural changes
During the past decade, low-cost carriers (LCCs) have rapidly grown their market penetration from 27% to 44%, as can be seen in Figure 7. By cutting on-board amenities, and using the direct-booking model, LCCs have been able to offer flight tickets at a lower fare than legacy carriers. To demonstrate this structural change, let us consider that the largest UK carrier based on passengers is no longer British Airways, but easyJet. Also, most passengers in Spain, Italy and Poland choose to fly with Ryanair, instead of Iberia, Alitalia and LOT. Finally, the dominating carrier in Eastern Europe is yet again another LLC, the Hungary-based Wizz Air 14.
To compete with LLCs, legacy airlines started to have their own low-cost carriers, either by starting from scratch or acquiring existing ones. Typical examples are Vueling from IAG, Transavia from Air France-KLM, Euro wings from Lufthansa. These low-cost subsidiaries seek to apply common practices of LCCs such as negotiating cheaper crew contracts, increasing aircraft density, and cutting down onboard amenities. Even though their cost bases will be lower than their parent airlines, it is unlikely that they can match LCCs costs soon. Low-cost airlines such as Ryanair and easyJet have been operating over 20 years. With the economy of scale, they can spread the fixed costs over more passengers given their high load factors and secure a substantial discount by buying aircraft in bulk. In addition, in-house LCCs face risks from trade unions due to paycheck differences between the parent companies and low-cost subsidiaries.
14 According to Dron (2018)- Legacy vs. Low-cost carriers: The Game is on Figure 7:
Market Share Low cost vs Legacy, Western Europe (%)
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As such, we don’t consider in-house LCCs as a big threat to traditional LCCs such as Ryanair, Wizz Air or easyJet.
Further market consolidation
Following the liberalization of European Air Transport market, European short-haul airline sector has become very fragmented. Statistics from OAG shows that market share of the top 6 European airlines represents 43% of total capacity, while the top 6 American airlines provide 90% of US domestic capacity. At the same time, Europe has a total of 217 airlines, which is remarkably larger than 100 airlines in North American. In fact, it has the largest number of operating airlines than any other region in the world 15.
The industry fragmentation has led to low operating margins shared among European airlines, as can be seen in Figure 8. Apart from a few leading players, several airlines were struggling to make profits. Having made losses for years, Air Berlin, Alitalia and Monarch finally went bankrupt in 2017 after their financial backers refused to inject more capital. In 2018, we again witnessed various airline bankruptcies from Primera, Cobalt, Azur air, Small Planet Airlines and SkyWork.
Given the rising fuel costs, we expect more airlines to go out of business in the next 1-2 years. In Figure 5, we can clearly see the negative relationship between operating margins and oil prices in the past decades. With an already low profit margin, some airlines will not be able to bear higher fuel costs. These struggling airlines are also facing pricing pressure due to overcapacity in the European short-haul sector. In Figure 9, we can see that capacity growth has surpassed demand growth, which leads to a declining revenue unit. This is mostly due to LCCs growing their capacity aggressively to gain more market share.
With lesser airlines competing for customers, European airlines will be able to increase its profits, and start to resemble the same margins of its North American counterparts. The consolidation process will make the largest airlines stronger and provide the solution for the problem of physical limit to growth. Healthy airlines will take over assets as well as airport slots from their bankrupt peers. This has been the case of easyJet with Air Berlin and IAG with Monarch.
Being the fifth largest European airline, easyJet will be among the main beneficiaries from the consolidation. It will be able to increase profit margin, gain market share from bankrupted airlines and extend its airport network.
15According to Powley (2017)– European airlines face more cuts and consolidation Figure 9:
ASK (capacity) growth exceeding RPK (supply) growth in Europe
(%) Figure 8: Airline Profit Margin in
2017 (%)
Source: IATA Statistics
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Partnership between LCCs and Long-haul airlines
Even though budget travel is often associated with short trips, there has been a growing number of long-haul operators provide flight tickets at very cheap price. This concept is known as “long-haul low-cost”. Amidst this trend, we started seeing several partnerships between short to medium-haul LCCs and those long-haul low-cost airlines, such as Ryanair and Air Europa, easyJet and Norwegian Air Shuttle. The partnership helps long-haul airlines expand to more airports while keep its cost base low. On the other hand, LCCs can feed into the hub-to-spoke network and create new revenue streams.easyJet is in fact an active player in this new field. In addition to its partnership with Norwegian Air Shuttle, easyJet has established collaboration with Virgin Atlantic Airways, Thomas Cook, WestJet and Emirates. Around 50% 16of its
flights can connect to airline partners’ flights to 14 destinations in Africa, the USA and Canada. This partnership allows easyJet to provide long-haul connectivity without having to purchase long-haul aircraft. Additionally, easyJet can increase its revenue and gain market share from legacy airlines in the long-haul market.
Past performance & competitive analysis
Past performance
To analyze the performance of easyJet, we will compare it with other airlines to assess easyJet’s cost advantage and efficiency. Based on FY 2017 Annual reports, we constructed a table of Cost per Available Seat Kilometers (ASK) for comparison purposes. In Table 1, easyJet’s cost based is compared with both traditional airlines and LCCs.
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From our chosen comparables, easyJet has the second lowest staff cost per ASK. Staff costs are not expected to further change since staff compensation is regulated and number of crew members per aircraft is enforced by aviation law. In addition, easyJet employs its staff under local contracts and most employees have permanent contracts, resulting in higher labor costs compared with Ryanair, yet still lower than the rest. However, as mentioned previously, we believe the group also benefits from higher staff productivity and therefore generates more revenue per employee than Ryanair. We believe that having a committed staff is one of the reasons for EasyJet’s high level of customer satisfaction and positive brand perception.
For airport and ground handling cost easyJet has the highest compared with IAG and Air France-KLM for instance. Since the above mentioned operate in the main airports, they should have similar fees. Thus, we see it as a case of inefficiency by easyJet and as an opportunity to improve. Ryanair has the lowest Airport and ground cost per ASK since it operates in secondary airports where fees are much lower.
For navigation and maintenance costs per ASK, easyJet is among the lowest only behind Ryanair which has the cost advantage in those variables. For selling and marketing costs, easyJet has the lowest cost among the considered airlines, where lower marketing spending is a part of their strategy to increase efficiency. Overall, easyJet has a cost advantage compared with the considered airlines only falling behind Ryanair who is the leader in terms of cost efficiency and Norwegian Air Shuttle. Considering that easyJet flies to the main hubs and focuses on business travelers, it has overall cost advantage over legacy peers IAG, AF-KLM, Lufthansa which makes their business model profitable.
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Competitive analysis
Competitive advantage
easyJet is differentiated itself from fellow low-cost carriers by their business strategy of focusing more on business travelers and flying to the main airports with a unique primary airport network as easyJet holds number one or number two position in 51 airports. This particularly appeals to business travelers, who have the need to travel within the peak hours, and time-conscious travelers, who would save time getting to the city from primary airports.
With the operations from Tegel airport take-over, easyJet gained more market space in Germany converting domestic flights which were before covered by bankrupt company Air Berlin. Tegel operating drove 3.9 million passengers flown as for September 2018 where 50% accounts for business travelers flying German domestic routes.
For instance, considering the European main hub route (London-Paris) covered by easyJet, LCC´s like Ryanair don´t have a flight connecting the two cities at the main hubs. Even tough Norwegian Air Shuttle covers the hub, it doesn't have direct flights which mean that travelers would have to do a stopover in Oslo (Norwegian main hub) which is not suitable for business travelers.
Battle of slots
EasyJet airport network is not something that other low-cost-airlines can replicate easily as it is dependent on the number of slots available in the airports.
For many airports, the demand for flights exceeds the existing available slots which can only be solved by airport expansions. The process of expansions of runways or airports is something that takes a lot of time. Meanwhile what can be done is air slot coordination and since Europe has most constrained airports like Paris CDG it comes as no surprise that Europe has the largest proportion of global slot coordination airports as it can be seen from Figure 11.
In this context, the Worldwide Slot Guideline (WSG) was developed to ensure a fair allocation in busiest airports (which are classified as Level 2 and Level 3 airports) like London Heathrow with over 78 million passengers.
easyJet can be considered as a valuable portfolio of slots as it has 89% capacity in constrained-slot airports as well as flying rights in the UK, Austria and Figure 10:
Proportion of Global Slot Coordinated Airports
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Switzerland. In addition, easyJet has the 48 markets pair between two primary airports differentiating itself from the competitors as shown in Figure 12.
By 2027, Heathrow 3rd runway is projected to launched and with more open slots at the most connected flights airport in Europe. Currently, Heathrow airport is not part of easyJet network. However, we see opportunity for easyJet to get some of the slots since according to the Worldwide Slot Guideline 50% of capacity of new available slots should be attributed to new entrants, favoring low-cost carrier rather than legacy airlines, marking easyJet a strong contender for the upcoming battle of slots.
With the unique network position and potential operation on Heathrow Airport in 2027, we think that easy can gain more market share and gain more connectivity around the world.
Key value drivers
Revenue
Total revenue is broken down into Seat revenue and Non-seat revenue. While Seat revenue includes ticket fares paid by customers and fees from the provision of checked baggage, allocated seating and extra services provided onboard, non-seat revenue consists mainly of commissions earned from selling services on behalf of partners and inflight sales. These are two different types of revenues, and therefore are separated as above.
Seat revenue is then divided into Revenue per ASK and ASK. ASK is Available Seat Kilometers, a commonly used metrics to measure the airline’s carrying capacity. It is calculated by multiple seats flown with the number of kilometers flown.
To dig deeper, ASK is broken down into Revenue per passenger (RPK) and Load factor. RPK is another typically airline metric that reflects the actual demand for air travelling and is calculated as the total distance traveled in kilometers traveled by the number of paying passengers (Airlinegeeks, 2016). The relationship between ASK and RPK is characterized by Load factor.
Costs
Total costs were broken down into Fuel costs, COGS and Selling and Marketing. The former is highly dependent on macroeconomics factors, and therefore should be separated from other costs. On the other hand, COGS, such as Airports and Figure 11:
Number of European market pairs
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ground handling, Crew, Navigation, Maintenance, is the direct cost attributable to the service delivery. We separated COGS from Selling and Marketing costs as COGS can reflect easyJet’s level of efficiency compared with its peers, whereas Selling and Marketing vary upon each airline’s strategies and therefore should be analyzed apart.
In addition, for Costs to reflect Revenues, all costs were broken down to per ASK unit, which will then be analyzed against its peers and easyJet’s future initiatives in order to arrive at the most accurate forecast. Finally, Costs per ASK will be multiplied with ASK to derive the incurred costs
.
Forecast
Income statement
1. Revenue Revenue per ASK
Revenue per ASK in 2019 is predicted to slightly decrease at 2%. This reflects a series of positive events from H1 2018 including the bankruptcy of Monarch, the IT meltdown of British Airways (BA) and the winter cancellations of Ryanair, which are all one-off events and unlikely to occur again. This also considers the uncertainty surrounding Brexit’s negotiation outcome, which has partly affected customer confidence.
In 2020, revenue per ASK will increase slightly. With the pricing pressure from rising oil price and IMO 2020, airlines will be faced with a dilemma. Increasing in the ticket price would lead to fewer customers, given the highly competitive environment and extra capacity. On the other hand, maintaining the same price level would hurt their bottom lines. They came up with the solutions: charging more for ancillary services such as allocated seatings, carry-on baggage, and boarding pass printing fees to offset the loss from ticket sales. Leading the wave in Europe, Ryanair and Wizz Air have just announced that they will be charging for carry-on baggage from November 2018 17. We don’t see easyJet as an
exception and believe that they will also be charging more for extra services, as can be seen in 9.9% increase in Ancillary Revenue per seat in 2018. Even though ticket price per seat will not increase significantly, rising fuel costs will still be passed down to customers through ancillary revenues. Hence, we forecast Revenue per ASK to increase 1% in 2020 and remain stable onwards.
17According to Topham (2018) Figure 12: Global passenger demand growth & capacity growth (%)
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Exceptionally, in 2021, easyJet’s revenue per ASK will slightly decrease at 1% as the UK officially leaves Europe following the transition period. We expect the pound to slightly tumble as the market is waiting to see UK performance in its first year leaving EU. Even though easyJet hedges 65% to 85% of its cash flow, the remaining is unhedged and therefore will be slightly affected by the pound’s devaluation.
RPK
As mentioned previously, RPK is highly dependent on GDP growth with a multiplier of approximately 1x to 2x. With European GDP forecast figures from the IMF, we performed a regression with GDP growth as an independent variable and European RPK as a dependent variable. The result showed that both intercept and variable are significantly different with a R square of 67.9%, and RPK growth can be computed from GDP growth according to the function bellow:
RPK growth = 0.0321 + 1.0964 * European GDP growth
In addition, from year the 2024 onwards, European RPK will gradually converge to the long-term RPK growth rate of 2.3%, which is the CAGR of the European airline sector until year the 2036 18. Therefore, RPK for European air travel sector
will be as it follows on Table 2.
However, it would be simplistic to assume demand for easyJet will closely follow European RPK even though it is operating within the European short-haul airline sector. easyJet’s past performance and its competitive advantage must also be considered. Reiterating our conclusion from Competitive advantage section, easyJet has a better-than-average performance compared with its peers. As such, we regard easyJet as one of the leading players in the short-haul European airline sector, particularly among low-cost carriers. Therefore, RPK in 2019 and 2020 are forecasted to be at 9% and 8% respectively, higher than European RPK of 5.52%. With its network of primary airport, we expect easyJet to have a steady growth fueled by growing percentage of business travelers. This also reflects the potential gains from bankrupted companies, namely Azur Air from Germany and Skyworks from Switzerland. Given that easyJet is rapidly growing its capacity in Germany at 50.9% thanks to the Tegel take-over, and in Switzerland at 8.6%, easyJet will be very likely to benefit from their demises. In fact, in case of SkyWork, Switzerland's FOCA19 reached an agreement for easyJet to carry
company’s stranded customers following the bankruptcy announcement.
18IATA Passenger forecast (2017) 19Federal Office of Civil Aviation Table 2 – Regression results for
prediction of European RPK
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From 2021 onwards, however, easyJet´s traffic demand will reduce as Brexit’s agreement will come into effect. As discussed previously, Brexit would cause 6% reduction in demand, due to economic contraction and pound’s devaluation. Accounting for 84% leisure travelers and 35% UK-EU flights, we estimated that easyJet’s demand will reduce approximately 2% in 2021 and 2022. We believe intra-EU flights will not be greatly affected, and that business customers will not be put off by higher prices, given their lower price elasticity.
After that, we predict easyJet’s demand will eventually converge to the long-term trend of 2.5%, slightly higher than CAGR of the European airline sector until the year 2036.
Load factor
easyJet’s load factor reached a record of 92.9% in 2018. We believe that this is the peak as easyJet’s strategy is to prioritize over maximizing profits, instead of further increase load factors. Nevertheless, in 2019, easyJet’s load factor will marginally drop to 92% due to overcapacity in the Winter 2019. In addition, easyJet recently announced a capacity growth of 10%20, which is slightly above
our forecast for demand growth of 9%.
In 2021, load factor will decrease at 1% because of Brexit. In the first year of Brexit, uncertainty will dampen consumer confidence and spending. As c.40% of easyJet’s revenue is from the UK, this will have an impact on the load factor. Nevertheless, we remain a positive outlook from the year 2022 onwards. Despite the high possibility of geopolitical and major macro issues on airline demand, global airlines industry has delivered relatively stable performance of mid-single digit percentage growth over the past five years, with long periods of mid- or high-single digit expansion from 1993-2001 and 2004-2008. The exceptions are only big financial, or the geopolitical crisis happened.
Therefore, under current macroeconomic environment, we predict that easyJet’s load factor remain high from 90% onwards. Demand for travelling fueled by tourisms has not shown any sign for stopping. Higher propensity for travel is among key emerging airlines markets such as India and China, both on short-haul and, increasingly, on long-short-haul as GDP/ capita increases.
Non-seat revenue
easyJet records Non-seat Revenue as commissions earned from services sold on behalf of partners ranging from in-flight sales, accommodation, car hire,
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insurance, and other add-on products. Within the tenure of the new CEO, easyJet will double down its effort tapping on a new revenue stream, by partnering with hotels and tour operators for cross-selling. Mentioned previously. easyJet launched “easyJet Worldwide” in September 2017, offering a channel for third party partner sales. It will also launch easyJet Holidays, a booking platform, in late 2019 to leverage customer data and offer more personalized packages to customers.
This new initiative will have a big appeal for business travelers and corporate flighting bookings, which currently account for 16% of total customers, the new initiative appears very attractive and suitable for corporate flight booking.
According to the analyst presentation in 2018, easyJet will establish direct relationship with the most popular European hotels by 2020. We see this as a lucrative opportunity for easyJet to increase its bottom line, since previously 20 million people who flew with easyJet then end up booking accommodation elsewhere. Therefore, we forecast non-seat revenue per ASK will gradually increase at a rate of 1.8% to 2.3%.
2. Costs Fuel costs
easyJet hedges between 65% and 85% of the next 12 months anticipated fuel and between 45% and 65% of the next 24 months anticipated requirement. This hedging policy helps to reduce short-term volatility in earnings.
To accurately project easyJet’s future fuel costs, we built a hedging schedule where Brent crude oil future prices are used. This is a reasonable assumption to make as jet fuel and Brent crude oil are both denominated in US dollars and are strongly correlated as it can been seen by Figure 14. In September 2018 Brent crude oil price was $/bbl. 82.72 which is that highest level reached since 2014 and the upgrading trend is expected to continue.
Figure 13- Brent Crude Oil vs Jet Fuel ($/bbl)
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As the airline hedges a significant part of their fuel requirement, we disregard a small portion in which easyJet does not hedge. We believe this is a reasonable assumption, as short-term fluctuation has an industry-wide impact and will be passed on to customers. As such, easyJet profits would not be affected.
COGS
The management guideline aims to achieve a target of flat constant currency ex-fuel unit costs in 2019. We believe this is possible given the continuous success of easyJet lean initiative, which delivered £400 million of savings over the last seven years and £85 million saved in 2017. In addition, given our peer comparison above, we still see scope for improvement in ex-fuel unit cost control. The specific areas for improvements are as follows:
Airport and ground handling
As mentioned previously, easyJet has the highest airport and ground handling cost per ASK. Therefore, we see this as an inefficiency as well as a potential for the airline to cut down costs. In fact, its Lean initiatives, whose focus specifically on airport costs, have proved to be fruitful: airport and ground handling cost per seat decreased by 1.3% at constant currency in 2017. Additionally, with easyJet’s recent appointment of DHL to take over its ground handling operation at London Gatwick, Bristol and Manchester airports, we see that easyJet will be able to gain more efficiency in this area. As such, airport and ground handling per ASK is forecasted to decrease gradually to 1.46 pence from 1.5 pence by 2025. This is thanks to the global expertise of DHL and its newly introduced innovations, such as biometric scanners and a bag drop area to reduce waiting times. However, we do not see easyJet’s airport and handling cost would reach the same level of Ryanair due to the difference in price points between primary and secondary airports. For that reason, cost per ASK will remain stable from 2026 onwards.
Navigation
With easyJet’s navigation cost being the lowest among its comparable, we believe it is unlikely easyJet can further drive navigation costs down, taking into consideration that the costs have reduced by 4% at constant currency in 2017. Furthermore, navigation cost is mainly determined based on the destination, the trip distance, maximum takeoff weight. All the elements are highly dependent on the airline’s offerings. As they are already factored into the ticket fares, we do not see this will not affect the easyJet’s valuation.
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In 2017, easyJet reduced its headline maintenance cost per seat by 7.2% at constant currency. This significant reduction was mainly driven by better component supply contract, and the fleet up-gauging as easyJet continues to replace its A319 with new A320 aircraft. We see easyJet will further benefit from the fleet up-gauging as an addition of 127 aircraft are waiting to be delivered in the future. Therefore, maintenance cost is forecasted to gradually decrease and would reach 0.27 pence from 0.28 pence by 2023. In addition to the new fleet, the cost reduction is driven using predictive maintenance on all its A319 and A320. This would help easyJet accurately predict when an aircraft or its components need routine maintenance, and therefore drive the costs down.
Crew
As mentioned previously, most easyJet employees have permanent contracts. As a result, it has higher staff costs than Ryanair, yet lower than its peers. However, Ryanair is notorious for labor strikes due to unreasonable salary and working conditions. In 2018, Ryanair’s strikes by its pilots and crew members disrupted 250 flights and affected 40,000 of its passengers. Therefore, we do not think easyJet should strive for the same staff costs of Ryanair, which would affect its performance and brand image. As a result, crew cost per ASK is estimated to remain constant at 0.6665 pence.
Selling and marketing
As discussed earlier, easyJet spent the least on selling and marketing compared with other airlines. This is partly since easyJet increasing focus on business travelers, who are less price-sensitive and less responsive to promotions. However, with Brexit coming ahead and declining consumer confidence, easyJet will have to increase its selling and marketing spending. This can already be seen in the new CMO appointment, and her £12m pan-European marketing campaign21. The campaign will run across social networks, cinema, digital
outdoor, but also TV, which would cost more. Additionally, its new booking platform, easyJet Holidays, and easyJet Worldwide are still under improvement, and would require upfront investment. Therefore, selling and marketing cost is forecasted to increase to 2.8% of total revenue starting from 2018 onwards.
Depreciation
Depreciation is calculated as a percentage of previous year PP&E, which has been stable in previous years. Since the aircraft’s average useful life will not
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2015 2016 2017 2018 2019 2020 2021 2022 2023
Seat revenue per aircraft 19.15 17.85 17.77 18.11 18.37 18.74 18.99 18.99 18.99 % growth rate -6.81% -0.43% 1.91% 1.43% 2.01% 1.33% 0.00% 0.00%
change significantly, depreciation is assumed to remain c. 5.5% in terms of PP&E.
Aircraft dry leasing
The proportion of leased aircraft to total operating aircraft has been relatively steady, at 26% on average. In 2019 and 2020, we predicted operating leased aircraft will increase to 27% of total aircraft, to fuel for new operations in Tegel. From 2021 onwards, leased aircraft will account only for 25% of total fleet, since by this time, the majority of easyJet’s ordered aircraft will be delivered.
To estimate future aircraft dry leasing costs, we need to calculate the price per each aircraft, which is approximately £1.6 million per aircraft. This rate is relatively in line with the market price, in which an A319 dry lease would cost £140,000 per month or £1.7 million per annum22. In addition, a 2% increase in the
lease rate per aircraft is included to account for inflation. With the projected number of operating leased aircraft and price per each aircraft, we then calculate future dry leasing costs.
Balance sheet
PP&E
Even though easyJet has placed an order of 167 new aircraft from Airbus, it is possible that, due to overcapacity, the airline does not need that many aircraft and need to request for an order delay or cancellation. To examine that possibility, we first calculated how many planes are required to generate future revenues, which fluctuated from 18 million to 19 million per plane.
Using the above information, required aircraft for future revenues is calculated. It is important to note that the new fleet has a higher seat number on average. The new generation aircraft consist of A320 and A320neo with 186 seats, and A325neo with 231 seats, compared with the old A319 with 156 seats. Since
22Avibroker (2018) Aircraft for lease
Table 3 – Proportion of Leased aircraft vs Owned aircraft
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aircraft with more seats will generate more revenue, we then calculate the new seat revenue per aircraft for the new fleet.
With the above information, the total operating aircraft, and owned aircraft were estimated:
From 2015 to 2023, easyJet required approximately 125 aircraft to fuel its growth. Even though this figure is slightly lower compared with the total delivery from 2015 and 2023 of 150 aircraft23, easyJet will also replace the new aircraft with its
old aircraft. As such, we see that easyJet will utilize all its ordered aircraft.
Next, to forecast capital expenditures, we multiply the aircraft to be delivered each year with its average price. Even though the exact price for each aircraft is not disclosed, the airline revealed the total list price of all aircraft, which is 167 aircraft for $14.3 billion. Taking into consideration Airbus aircraft price as of 2015, our best guest for the discount rate offered to easyJet is approximately 18%. For such a major airline like easyJet, we believe this number is reasonable.
In addition, after the recent acquisition of Air Berlin as well as its slot in Tegel, we believe that easyJet will soon have to place new order in 2024. As the airline already up gauged its fleets, new orders will be rather incremental this time. Hence, the discount rate will be lower, at 10%.
Finally, capital expenditures were derived as follows:
23Half year results statement 2015, p25
Table 6- Aircraft Price 2015 vs 2018
Table 7- Aircraft Delivery Schedule
Table 5- Owned Aircraft estimation
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With the projected capex, PP&E was calculated as:
PP&E = PP&E last year + CAPEX - Depreciation
Valuation
Discounted cash flow
In order to value easyJet, we used the Discounted Cash Flow model accounting for future cash flows, the growth of cash flows and the opportunity cost of capital as the discount rate.
▪ WACC
Cost of Equity
To calculate it, we used the CAPM method where the cost of equity is a combination of the risk-free rate, the beta of the company as a risk sensitive factor towards the market.
After the Brexit referendum, UK credit rating dropped from its high-level AAA to AA. Since easyJet is based in the UK, we decided to use the UK 10Y Government Bonds yield to better reflect risk-free rate of the company. We used 10Y longevity bonds since they are more suitable for our chosen forecasted period of 10Y. In this case, we use the yield 1.625% as our best proxy for the risk-free rate.
easyJet belongs to FTSE 100 Index. For that, we use the market risk premium of this representative big group of UK companies, 5.93% as our proxy for the value of MRP since the Index return will be more reflective of premium to shareholders considering the risk of Brexit.
For the beta estimation, we calculated the arithmetic average of the unlevered betas of seven airlines, namely 3 low cost (Ryanair, Wizz Air, Norwegian Air Shuttle), 3 flag carriers (Lufthansa, Air France-KLM, IAG) and easyJet itself. Not only they operate in the European short-haul sector, they are the top 7 players
24based on the number of passengers25. The similarity between the size and
industry ensures the comparable share the same level of risk and growth with easyJet.
After unlevering the beta of comparable, we calculated the average value as easyJet’s raw beta. We then re-levered the beta using easyJet’s long-term target
24 Turkish Airlines and Aeroflot were excluded given that they are based in a non-EU country. As such, they will have a different systematic risk compared with easyJet 25 Passenger volume in 2017
Table 8 – Beta Unlevered of Comparable group
Table 9 – Cost of Equity estimation using CAPM equation
Source: Analyst estimates
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net debt to Equity ratio of 40% which represent the average LT Debt to Equity ratio from the easyJet peers considered above and easyJet itself according to Bloomberg data. We believe this value better represents easyJet’s long-term capital than the current Net D/E of -9%. In addition, in 2019, easyJet will no longer be able to sustain its net cash position, as it will have to pay for new aircraft deliveries. For the tax rate, we use the new UK Corporate tax rate 17% set by the UK government and that is expected to be maintained onwards. All the 3 variables above considered, a levered beta of 0.58 for easyJet was estimated. The cost of equity was then calculated using the CAPM formula which equals 6.61%.
Cost of Debt
Cost of debt was calculated using the credit spread method. Given easyJet ‘s long-term bonds of BBB+, cost of debt was estimated to consist of risk-free rate and credit spread of 1.34% which value estimated was 2.97%. We also attempted to use another method for cost of debt estimation, using the following formula: Cost of Debt= Yield - Probability of default * Loss given default (LGD). With a 10Y yield of 3.03% according to GBP BBB chart bonds, and a probability of default of 0.01% and a loss given default of 56.48%26, cost of debt was
estimated to be 3.02%, satisfying the Rf<Rd<Yield condition. As two methods produced highly similar results, we will proceed with the first method, and use 2.97% as the cost of debt. With the above information, a Weighted Average Cost of Capital of 5.24% was derived.
▪ Growth rate
The implied NOPLAT long-term growth rate in FY2027 is 2.12%, which is in line with the European long-term GDP growth from OECD of 1.9%. We consider the NOPLAT growth being slightly higher than GDP growth reasonable, as it is not unusual for airlines to grow marginally faster than the economy.
Enterprise value, Equity value and Target price
EasyJet’s Financial Statements were forecasted for a period long enough for the steady state to be reached, thus projection was made until FY2028. Using the free cash flow of FY2027, the terminal value using a perpetuity formula was calculated where the long-term growth rate and WACC were 2.12% and 5.35% respectively. Thus, Core Business Value as for December 2019 was estimated to26 Moody’s Annual Default Study: Corporate Default and Recovery Rates Table 11 – Cost of Debt
estimation using Bond´s Yield
Source: Analyst estimates
Source: Analyst estimates
Table 10 – Cost of Debt estimation using Default Spread
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be £6,513 million. Adding up the non-core invested Capital of £92 million, the EV amounts to £6,500 million and adjusting Net Financial Assets, the Equity Value amounts £5,301 million.
With estimated a target price of 13.34 £, we estimated the expected capital gain and the dividend yield for shareholders which amount to 20% and 3% respectively. The expected total return is 23 % which translate into a BUY recommendation for Investors.
Multiples
In order to complement the easyJet Valuation, we decided to estimate airline´s value using its public trading comparables. However, it is important to note that this method is not forward-looking, hence, does not reflect easyJet’s future growth. We chose the same set of comparables in Cost of Equity section, and EV/EBITDAR multiple. EV/EBITDAR was used instead EV/EBITDA for comparability purpose, given that some airlines own most aircraft whereas others prefer to lease their aircraft.
Considering EV/EBITDAR multiple from the trading peers, we calculated the minimum , median , average , maximum and the percentile values where the range is 6.6x .Estimated price through multiple was computed according to table 9 below using the 75% percentile27 which estimated the share is of £ 11.47
which is lower than estimated using DCF yet still yields the same BUY recommendation. Even though the multiple method and DCF method have both the same recommendation, we decided to use DCF since Multiple valuation does not consider the expected value of future cash flows nor it incorporates the risk associated with the company risk measured by the WACC.
Sensitivity analysis
Sensitivity analysis was performed to evaluate how sensitive the share price is by changes in key variables. Our chosen variables that have the possibility of affecting the overall value of the company were WACC, the long-term growth rate and Load Factor.
27We believe that easyJet outperforms the market competitor, thuswe use the 75% percentile to reflect that Figure 15 – EV/EBITDAR
Multiple for comparable
Source: Analyst estimates
Figure 14 – Enterprise Value & Equity value
Source: Analyst estimates
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WACC and g
Stock prices are very influenced by the assumptions behind the DCF valuation method, for that it would only make sense to study the combined effect of WACC and g since the terminal value formula incorporates both values. For the long-term growth rate changes of +/- 1% were chosen which are within the parameters of Europe nominal GDP growth. For the WACC, the interval of doubt chosen was [4.60%; 5.98%] which reflects our interval of the beta levered [0.48;0.68] where the lower limit is beta estimation using average of low-cost comparable and upper limit is beta estimation using the average of legacy comparables since they operate in main hubs just like easyJet. The combined effect was the variation of price from £8.46 up to £21.93 which translates to changes of price of -38% and 58% where we can conclude that Share price is very sensitive to changes in WACC and g.
Load factor
Even though easyJet load factor values have been stable, we choose to evaluate the impact of the variable in the share price, so we choose as our interval of doubt [-1%;1%] where the share price is affected by -21% and 36% respectively the share, where the impact is lower scale than the previous case.
Scenario Analysis
When there is so much uncertainty surrounding Brexit, it is important to assess the impact of different Brexit outcomes. Previously, soft Brexit Scenario was used as our base model. In this case, a Buy position was recommended because easyJet’s positive future cash flows outweigh Brexit impact. In this section, we attempt to test if the same BUY position can sustain even with a Hard Brexit scenario. Our assumptions are as follows:
Hard Brexit, as mentioned above, is equivalent to UK escaping the EU regulations and tariffs thus leaving both the EU single market and the customs
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union.28 In this case, there will be much more economic damages to both parties.
Demand will decrease of 8%, where 5% comes from reduction of UK GDP and 3% from the currency devaluation. Given that only 84% leisure travelers and 35% UK-EU flights will be affected, we estimate 3% decrease in traffic demand. Thus, we reduce RPK growth rate for 2021 and 2022 to 5%. In addition, we forecast exchange rate to be 5% lower than it would be in our base case Brexit for 2021 and 2022. This will impact fuel costs, leasing costs and other US denominated items. All the above considered, the price per share in Hard Brexit scenario amounts to £12.53.
Summing up we have 2 main outcomes:
• Hard Brexit - Severe Shock Scenario as the less likely (probability of 30%) since it would lead to severe economic damages to both UK and EU and if no agreement deal is made until January 2019, the Prime Minister would have to make statements the parliament members and if rejected it is most likely the extension of transition period or a second referendum.
The estimated Target price £12.53 which yields a BUY recommendation. • Soft Brexit (Shock) with an assigned 70% probability as the base Scenario yields an estimated Share Price of £13.34, thus a BUY recommendation.
Weighted Average Share price is as follows:
Probability of Hard Brexit (30%) x Share price HB (12.53) + Probability of Hard Brexit (70%) x Share price SB (13.34) = £13.10
Taking into account all the above scenarios the weighted average share price equal to £13.10 which is very similar to the value estimated using the DCF approach and is in close range to the value arrived at using the normal DCF approach above. Even with a Hard Brexit scenario, we are confident of maintaining a BUY decision which reflects our positive future projections for easyJet.
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Annexes
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Disclosures and Disclaimers
Report Recommendations
Buy Expected total return (including expected capital gains and expected dividend yield) of more than 10% over a 12-month period.
Hold Expected total return (including expected capital gains and expected dividend yield) between 0% and 10% over a 12-month period.
Sell Expected negative total return (including expected capital gains and expected dividend yield) over a 12-month period.
This report was prepared by [Marcela Alberto & Minh Hoang], a Master in Finance student of Nova School of Business and Economics (“Nova SBE”), within the context of the Field Lab – Equity Research.
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