Red Sky Ahead for Ryanair
Wednesday June 2, 7:10 am ET
By Peter Eavis, Senior Columnist
Michael O'Leary's last-man-standing strategy is looking very shaky.
The outspoken CEO of Ryanair, the big European budget airline, argues that his company will emerge victorious from a brutal fare war. But results that came out Tuesday for Ryanair's 2004 fiscal year, ended March 31, suggest the company may never again report the sort of earnings that once caused its stock to soar.
Indeed, the 2004 numbers and comments made by O'Leary suggest that the chief exec has no convincing recovery strategy for this new, harshly competitive environment.
With the company's American depositary receipts, or ADRs, nearly 50% off their 52-week high, some investors are eager to know when to buy Ryanair stock. On Tuesday, O'Leary said that after a long, hard slog, his company would be well-placed to trounce the competition. But the 2004 numbers show an airline that is attempting to fly with broken wings. Ryanair is becoming incrementally less profitable on each new dollar it invests in its business -- and it actually a made a negative return on capital employed in the fourth quarter.
In the 2004 fiscal year, Ryanair posted net income of 215 million euros, using U.S. generally accepted accounting principles, down from 242 million euros in fiscal 2003. It actually made a small 2-million-euro loss in the fourth quarter. Such a setback would have been unthinkable just a year ago, when earnings growth was robust and O'Leary was the toast of Wall Street. Ryanair ADRs rose 21 cents to $30.90 Tuesday.
Seeing Red
O'Leary says that because Ryanair has lots of cash in the bank and a low-cost operation, it can take on all competitors and come out ahead. But while Ryanair will likely survive, its profits will suffer badly and it will be dogged by tough competitors for as long as a market for low fares exists in Europe. It has been O'Leary's massive miscalculation to believe that only his airline can offer something as simple and commodity-like as budget air travel.
He half admits as much in his rhetoric. "One thing I don't want coming out of this conference call is optimism," O'Leary said Tuesday on an earnings call. He is quick to give everyone the message that Ryanair will come out on top. But that's far from certain, looking at what came out Tuesday.
First off, an important indicator of profitability sank into negative territory. Return on incremental invested capital, whose methodology can be found here, is a yardstick that Detox has applied to Ryanair over the past year. In the fiscal fourth quarter, that return sank to minus 7%, from 18% in the third quarter and 55% in the year earlier quarter. This is a clear sign that the company is making less and less on every new dollar it employs in the business. It indicates that O'Leary, believing his own hype that Ryanair was indomitable, has continued to spend heavily on a fleet with slumping profitability.
It appears that O'Leary thinks he can win the fare war by driving down prices further than can be borne by competitors. To be sure, he was willing to suffer a big drop in average fares in 2004, when they fell 14% to 40 euros, from 46.50 euros. One way in which O'Leary likes to show that an average fare decline is all part of the plan is by pointing to passenger growth. For example, in Tuesday's press release, Ryanair said that its 47% increase in passenger traffic in 2004 "was driven by significantly lower fares." There's one big snag with that line of argument -- average fares fell precipitously in the fourth quarter, and so did passenger numbers. The average fare plunged 9% to 32.27 euros from 35.62 euros in the third quarter, while passengers fell 6% to 5.73 million. There is no seasonality in this, since in 2003, passengers actually went up 4% from the third to fourth quarters.
True, last year's Iraq war and an acquisition may have skewed passenger numbers. Even so, the fourth quarter is strong evidence that Ryanair is in that nightmarish position of cutting fares and attracting fewer, not more, passengers.
Going Hiking?
There are other reasons to be worried. Ryanair execs could give average fare guidance for the next two quarters but not for the 2005 full fiscal year. This sent shivers down the spines of some analysts who interpreted the refusal as a sign that management has lost control of the situation. J.P. Morgan analyst Chris Avery slashed his 2005 earnings estimate to 162 million euros from 222 million euros. Ryanair is currently guiding investors to expect earnings of 200 million euros or higher.
O'Leary unconvincingly brushed off two areas of concern -- higher fuel costs and the European Commission's ruling earlier this year against Ryanair's allegedly anticompetitive deal with Charleroi airport near Brussels. Ryanair is hedged on fuel costs only until the end of September, and it is betting that oil prices will come down in the winter. Ryanair says it will absorb higher fuel costs through cost savings in other areas. But O'Leary conceded on the conference call that there were no longer big and obvious ways to cut costs at the company.
As for the Charleroi, the Ryanair bears have argued that the ruling will force many of Ryanair's airports to hike fees to abide by new European Union guidelines. O'Leary said that the earnings guidance didn't factor in higher airport costs due to the commission's ruling. So if, as is likely, the ruling does boost airport costs, expect it to reduce the chance of Ryanair hitting the already lackluster guidance.
O'Leary also made an argument that was starkly, and therefore suspiciously, at odds with everything he has said before about airports. O'Leary said that Ryanair was going to stay at Charleroi even though it has been offered cheaper deals by several other airports. In the past, Ryanair has argued that it will always look to move to cheaper airports, especially when it is facing regulatory problems at a more expensive airport.
The fact that it has no plans to move from Charleroi suggests either that Ryanair no longer follows that strategy, or that the offers from other airports may not be as attractive as O'Leary claims.
