European budget airlines: not to be underestimated

May 14, 2011

Budget airlines have looked down on their network carrier competitors for years. We actually make money most of the time, they crow (it does not take much to feel superior in a sector that routinely fails to cover its cost of capital). This year, though, higher oil prices should in theory erode their competitive advantage, since fuel accounts for a higher proportion of their costs. They also lack price-insensitive business travellers who can help pay for more expensive fuel.

Worried investors should not underestimate the budget airlines, though. Over the past five years, the oil price has risen 60 per cent, yet budget carriers have held total unit costs steady or even cut them, by pruning crew costs and getting cheap deals on planes. They also use their planes more efficiently. Europe’s network carriers, which time their short-haul flights to feed long-haul routes, keep their planes in the air for 6 to 7 hours a day, according to Deutsche Bank. Ryanair and EasyJet keep their planes flying for 9 to 10 hours a day.

Even if budget airlines now struggle to shave off more costs, they should be able to increase revenue by taking market share from the network carriers. EasyJet and Ryanair are both moving to more mainstream airports; EasyJet is actively targeting business travellers. This strategy depends on decent execution, something EasyJet still needs to prove after a summer of operational mistakes. Ryanair’s management, though, is second to none. And whether by luck or judgment, it has hedged 90 per cent of its fuel needs this year, compared with the European airline average of 60 per cent.

As the airlines report their first-quarter results this month, Ryanair’s valuation (its lowest since the recession at 10 times next year’s expected earnings) looks too low. A good business model with good management can ride out all kinds of storms.

Source: Financial Times (LEX)