Key Takeaways
- European travel demand was resilient in the second quarter, even as higher fuel costs hit profits across the sector
- Ryanair remains Morningstar’s top pick at current valuations, though IAG and Air France-KLM showed strength through the second quarter.
- EasyJet’s GBP 5.7 billion takeover by US private equity firm Apollo is likely to complete.
Karen Gilchrist: European airlines are back in focus at the close of the peak summer travel season. Second-quarter earnings showed travel demand holding up, even as airlines and consumers navigate higher costs and geopolitical risk. Meanwhile, a takeover battle for low-cost carrier easyJet shone a spotlight on airline valuations. To discuss what all of this means for the sector and investors, I’m joined by Morningstar equity analyst Loredana Muharremi.
Loredana, let’s jump straight into second-quarter earnings. Now, you mentioned a divergence between network carriers and low-cost carriers in terms of their revenue quality, particularly their ability to mitigate the impacts of the Iran war and higher fuel costs. Just expand a little bit on this and what you were seeing with particular companies.
Loredana Muharremi: Sure. Hi, Karen. So the takeaways from the quarter that, as you said, demand remained resilient, but higher fuel costs reduced profit across both network carriers and low-cost carriers. The main difference among the two groups was that network airlines were better positioned to recover part of that increase through higher fares.
In fact, if you look at network carriers, they maintained a flat capacity overall and benefited from temporarily reduced Middle Eastern competition, traffic rerouting through European hubs, particularly towards Asia, and continued strength in premium and business travel. However, this pricing support was insufficient to protect margins, because many tickets had been sold before the fuel price increase, and therefore did not reflect the higher cost. On the other hand, low-cost carriers continued adding capacity because much of that growth had already been committed through aircraft deliveries, and this put greater pressure on peers, with lower pricing required to maintain the high load factors.
IAG and Air France-KLM Outperform Low-Cost Airlines
Karen Gilchrist: Interesting. Were there any particular winners or losers from this earnings season that you would call out, and any trends that you think we can take away from consumer patterns as they stand?
Loredana Muharremi: Yeah. There were no outright winners because profit declined across the board. But relatively IAG IAG delivered the strongest overall performance, combining resilient pricing with better cost control. And IAG’s performance was followed by Air France-KLM EPA, which achieved the strongest commercial performance, with fuel recaptured at around 85%, while Ryanair RYA was the most resilient low-cost carrier. However, operating profit for both Ryanair and Air France-KLM declined by more than one third.
On the other hand, Wizz WIZZ was the clear loser as it underwent the largest capacity expansion, and much of it was deployed on immature routes, which required even heavier fare stimulation. And in terms of consumer patterns, as we said, premium and business demand remained very strong, particularly on North America and Asian routes. Leisure demand also remained resilient, but customers proved to be more price sensitive and booked closer to the departure date due to the political uncertainty, not unwillingness to travel. So this shorter booking window results in reduced airline visibility over future load factors. And while network carriers could tolerate weaker early bookings, because capacity was constrained and premium demand strong, low-cost carriers had to fill more seats, so they discounted earlier. What we saw at the end was a strong closing demand that ultimately filled the aircrafts, but could not recover fares sacrificed earlier.
Ryanair Remains the Top Pick
Karen Gilchrist: We have seen those pressures playing out on airlines’ share prices through the course of this year. Many of these companies now trading in line with your fair value estimate. Ryanair being the only one that you continue to view as undervalued, despite having slightly revised down that estimate after Q2 results. So would Ryanair still remain your top pick? What are some of the attributes that stand out for you there?
Loredana Muharremi: Yeah, at this current valuation Ryanair continues to remain our top pick. As we said, it had the strongest relative performance among the low-cost carriers. The disappointing result reflected weaker fares across European short-haul routes, and the sharp increase in hedged portion of the fuel bill, rather than that of the underlying business. We continue to believe that Ryanair remains better positioned than its competitors, as it has the lowest cost base, the highest level of fuel hedging, and the strongest balance sheet. The airline has also slowed growth; that’s led us to lower our fair value. But it’s also moving aircrafts towards airports that are offering lower charges, while future deliveries of the MAX-10 aircraft will reduce its cost base.
Eventually, what we expect is that higher fuel and operating costs will force weaker airlines to raise fares or reduce capacity, and this gives Ryanair an opportunity to widen its cost advantage and gain market share. So with the shares trading at around a 20% discount to our fair value estimate, we believe that Ryanair offers a strong combination of relative downside protection, market share opportunity and earnings upside when pricing improves.
easyJet Takeover Poised to Complete, Spotlighting Airline Valuations
Karen Gilchrist: We also saw that easyJet EZJ has agreed to a GBP 5.7 billion takeover by Apollo, following that bidding war with Castlelake. What does that tell you about the strategic value of the company and what public markets might have been underestimating up until now?
Loredana Muharremi: Yeah, the key message that we saw from this is that easyJet was trading materially below the value that a long-term buyer placed on the business. Before the acquisition rumors, the shares were trading at 399 pence, so well below the 715 pence of Apollo’s offer, while the competing interest from Castlelake reinforced that this was not an isolated valuation view. So this would indicate the market was heavily discounting easyJet’s strong position in slot-constrained airports, the growth of the holiday business, and its aircraft delivery pipeline, focusing too much on the near-term fuel and pricing volatility.
Karen Gilchrist: What do you view as the likelihood that that deal will now go through, and do you think there’ll be wider ramifications for the industry?
Loredana Muharremi: Well, we believe that the probability of completion is very high. Our fair value is based on a 90% probability of the deal closing, and the market seems to have a similar view, as the shares are trading around our fair value estimate. This is now a firm offer, unanimously recommended by the easyJet board, and the founder’s family has committed his support. The principle remaining risk is regulatory execution, particularly the ownership structure required to preserve easyJet’s European control.
The transaction also requires shareholder and court approval, but the commercial obstacles are relatively limited. For the sector in general, the deal might imply that list airline valuations might not fully reflect the replacement value of their platforms. Therefore, the transaction is a positive revaluation signal for the sector, but not automatically a positive signal for fares or industry margins. This is an ownership change, not an operational consolidation, so it does not remove aircraft or capacity from the market.
Karen Gilchrist: And just finally, as we close out the summer season, what key trend or metric do you think investors should be looking out for as they look ahead to Q3 earnings?
Loredana Muharremi: Yeah, the key trends going into winter is whether slower capacity growth begins to improve capacity and close the gap between fuel increases and fares. Network carriers are already removing inefficient capacity and prioritizing stronger long-haul routes. Ryanair, as we said, is slowing its growth, while higher fuel and operating costs are expected to force weaker competitors to reduce flying. Wizz remains the exception in the near-term because it still has significant new capacity to absorb, although those routes should gradually mature.
So this creates the potential for improvement in two stages. Network carriers should benefit first, as more tickets sold after the fuel price increase enter the booking mix, improving the fuel recovery. While for low-cost carriers, pricing will improve only when capacity growth slows and the need for fare simulation declines.
Karen Gilchrist: Loredana Muharremi, thank you so much for joining us. For Morningstar, I’m Karen Gilchrist.
