Both British Airways (BA) and Ryanair (RA) are successful airlines at the top of their respective markets. BA is a more traditional, long haul full service carrier, while RA is part of the new bread of short haul, low cost, low frills carriers. The aim of this report is to give an overview of the industry, and the two companies, looking briefly at their history and future strategy and then to perform a financial analysis on both companies from users perspective: long-term investment for the common shareholder, creditors, analysts and providers.
Industry Overview
The airline industry, as many industries, is an imperfect oligopoly. A few carriers dominate long-haul traffic, while several dozen small carriers compete for short-haul flights. After five consecutive years of losses, major providers are losing market share.
S&P Airlines stock price underperformed the overall market. In 2004, the overall airline industry lost $5 billion dollars. To overcome this situation, large airlines are undertaking aggressive cost cuts to survive, but many of them have been unable to offset oil prices cost increase. Oil prices, labour costs, overcapacity, competitive pressures and a high debt to assets ratio are driving major airlines to ally, merge or change dramatically its business strategy in order to survive. British Airlines and Ryanair have been successful during this difficult period.
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Oil prices. Airlines are energy-intensive operators. Fuel costs accounted for 19% of total revenues in 2004, versus 15% in 2003. Incumbent airlines have been forced to acquire new airplanes and to reduce waiting time in airports.
Labour costs. Airlines are intensive in capital, labour and technology. Labour costs represented 36% of the revenues of the industry in 2004, down from 39% in 2003 and 44% in 2004. This is forcing major carriers to enter into salaries and benefits renegotiations, including pension plans.
Overcapacity. Low fare and regional airlines are entering to markets that were dominated by big airlines. The cost structure of low cost airlines (low labour, maintenance and fuel costs) is 40% lower than major airlines. A 50% load factor break-even point allows these companies to cut prices and continue its market share expansion. Discount carriers are growing rapidly, offsetting capacity cuts by the incumbent carriers in niche markets.
Competitive pressures. Airlines compete in both, service and price. Because airlines have high fixed costs relative to marginal costs, fare wars are common when capacity exceeds demand. Overcapacity is putting pressure on prices since 2001, and low- cost carriers are thriving in this challenging environment. United Airlines and US airways filed for bankruptcy in 2002. Delta, after a $5.2 billion net loss in 2004 and a debt burden of $21 billion, filed for bankruptcy this year.
Debt. For major airlines, interest expense averaged about 4% of revenues in 2004. Some airlines have filed for bankruptcy, but most of them are using cash and debt to survive to this crisis. Many are in their debt limit. High debt levels are increasing interest expenses, while the interest earned and investment income are diminishing.
British Airway (BA)
British Airways is the largest airline in the United Kingdom and one of the largest in the world with a total number of employees about 50,000 and a route network comprised of 150 destinations in 72 countries. Its fleet is composed of more than 350 aircrafts. BA is the airline company with the most flights from Europe to North America in the world.
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BA was formed in 1973, as the outcome of the merger between State-owned British Overseas Airways Corporation to British European Airways. The Conservative Government then privatised the airline in 1987. During the 90s, BA was the world’s most profitable airline. Its slogan was: “The World’s Favourite Airline”. In addition to jointly operating the famous Concorde supersonic airline, it pioneered “flat-bed seats” for first class passengers on long hauls. Moreover, BA was a founding member of the Oneworld Alliance of eight airlines, including such carriers as American Airlines, Iberia and Qantas Airways.
However, from 1996 onwards, the company entered a period of turbulence. Increased competition, high oil prices and a strong pound all hurt profits. In 1999, BA reported a 57% slump in profits, the worst since privatisation. Furthermore, the terrorist attack on the World Trade Centre on 11 September 2001 the airline industry led to a massive downturn in passenger traffic. Airlines that were most affected are those high-price international carriers like British Airways. BA dropped many of its long-term unprofitable routes in October 2001 in an effort to keep its financial head above water. Over 20 aircraft have also been withdrawn from line service.
During fiscal 2005, the company carried more than 35 million passengers on its services. For the three months ended 30 June 2005, BA’s revenue increased 8% to 2.06 billion GBP. Net profit totalled 90 m GBP, up from 23 million GBP.
Ryanair (RA)
Ryanair was Europe’s original low-cost airline. Started in 1985 it carried 5,000 passengers in its first year between Waterford (Ireland) and London Gatwick. In the early years its strategy was more in line with the traditional airline. Then in 1990 as price competition increased and after the introduction of a new management team the airline concentrated on the no frills and low price model of Southwest Airlines (USA) not previously seen in Europe. Since then RA has grown immensely, now it operates a fleet of ninety-one aircraft over a network of two hundred and twenty nine routes carrying over twenty four million passengers last year.
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This growth and sustainability of the company has been driven by a very aggressive and simple strategy of keeping cost and prices low. Ticket prices can be as low as 0.99 GBP, with the average ticket price being 21 GBP (easyJet’s average price is 42 GBP).
The firm has being able to do this via cost saving schemes, from the more obvious such as minimizing the plane types (reducing the number of mechanics), charging for in-flight refreshments and using out of town airports (lower landing costs and quicker turnaround times) to the more extreme such as; crew having to pay for it’s own uniform and head office staff having to buy their own pens and being banned from charging their mobile phones at work, to keep costs down.
The on going strategy is of further growth via more routes and going head to head with the more traditional airlines such as BA. RA has options and firm orders for another 140 planes for delivery during the period 2008-2012. By this time RA predicts they will have surpassed all other airlines in Europe by carrying over 70 million passengers a year. Also, if one is to believe the press and the often-quoted Chief Executive Michael O’Leary, further unimaginable extreme cost cuts will be implemented such as scrapping window blinds and seat pockets and even banning check-in luggage.
Key Ratios.
In analysing an airline there are a number of key ratios that an analyst should review in determining its condition and viability. These are what airlines consider as ‘Key Factors to Success’ and are Revenue-passenger miles (RPMs) and Available seat-miles (ASMs).
These ratios are determined from figures not found within the standard financial report published by a company, so we will not dwell on their significance. Despite this there are a number of key ratios that can be determined from an airline’s balance, income and cash flow statements that should be reviewed. Apart from the usual ratios indicating profitability, operating performance, liquidity and debt structure that are reviewed in varying depths within this report the core ratios we concentrated on are:
* Operating Performance
* Fixed Asset Turnover.
* Debt Structure and Liquidity.
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* Cash flow health or burn rate
Operating Performance.
Operating ratios were evaluated over a five-year period. This may appear a long time period, but we feel this will allow us to see the impact of major events such like the 9/11 attacks and see longer term trends which would not be noticed by concentrating on a shorter period of 2-3 years.
Our primary goal is to compare how well both companies operate in their respective market segments.
The first indicator is the Operating Profit Margin (OPM) measuring the overall efficiency of the company. On the one hand RA show a high OPM, which has increased from 2001 to 2003, without any impact in the downturn period of end 2001 and 2002. These benefits made up until 2003 allowed for the acquisition of Buzz, a subsidiary of KLM with the relative impact now seen in their operating profit margin. RA made an average of 22% net benefit during this 5 years period, 2001 to 2005.
On the other hand the effects of the 9/11 attacks seriously impacted BA. As of September 20th, 2001 BA announced 7000 layoffs. Its operating profit margin went down to -1.3% and it registered a net loss of -1.7% of total revenues. As of 2003, this has reversed and BA has started to improve as the whole Airline Industry did. Its operating margin continues to remain low and may impact its capacity to face new challenges associated to increasing of the oil prices.
Our second operating indicator was the Return On Assets or Investment (RoA).
This indicates the profit earned relatively to the investment made by the company in total assets. During the period:
– RA has maintained a flat RoA at around 10% despite its acquisition in 2004
– BA has recovered from 2002 and its RoA has considerably improved at 5%
We realise the importance of this indicator as and address in more depth later on (see Asset Turnover section).
The Account Receivable Turnover (ART) ratio provides an average figure on how often each company collects receivables. It allows the assessment of both the quality of the receivable and the efficiency of the company to collect its revenues.
We can see that RA is 6 to 10 times more efficient that BA in it’s collection. This is explained by the difference in their customer base. Ryanair primary targets home users and receives payment up front via Internet. On the other hand, British Airways has a large set of corporate customers, which will tend to prefer regular and global payments, rather than an individual one for each flight taken. The result is an average duration of 5 days for RA to collect its receivable versus 35 days for British Airways.
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We can see that in 2003 the collection of receivables was a major concern for BA (more than 3 months) and that a drastic change in their methodology has allowed this to improve sharply.
As a result Ryanair and British Airways, which show rather the same Asset Turnover, are very dissymmetric in their profit margin. They are both airlines, but do not operate in the same market segment.
Asset Turnover
Asset turnover (AT) implies the ability of the management to generate profit from the assets of the company. Given that the RoA is derived from this figure there is obviously a correlation between the two. Of particular interest to us was the Fixed Asset Turnover (FAT).
In the airline industry where equipment, fixed assets (aeroplanes), account for almost eighty percent of a firm’s total assets it is important we pay attention to and analyse this. Obviously the quicker an aeroplane gets to the end of its useful life the sooner it must be replaced, this represents a significant expense. The key factor in an aeroplane’s useful life is not the number of miles it flies rather the number of flights it performs. The fuselage is put under significant stress during take-off and landing, hence depreciation of its life span is accelerated with each. What can be seen from the balances sheets for the period 2001 to 2005 is that BA increases from 0.9 to 0.92 and RA decreases from 0.81 to 0.72 and overall, BA has a better assets turnover than RA. This is what we would have thought given that RA operates solely in the short haul market where on average its planes must perform a greater number of flights. Although one would expect as BA’s long-term strategy of the smaller Boeing flying more often for there fixed asset turnover to deteriorate slightly. We would also expect this figure to improve slightly for RA once the new planes are in active services, this figure can be skewed slightly by an original investment.
Capital Structure.
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The capital structure shows the extent of a firm’s financing with debt.
Major airlines haven’t thrived well in the current low level airfares and have increased their already huge debt. As a consequence some are even fighting for survival. Airlines that operate with low costs and low fares have found it much easier to cope than their higher-cost competitors and have not increased their debt to the same extent.
For BA, the amount of debt required to finance investments in assets has been very high cause and accumulated for several years up until 2002. From there the proportion of debt has decreased when BA began restructuring and cost cutting after 9/11 and investment stopped. As mentioned high proportion of debt is common in the airline industry but there is still a high risk, with any level of debt that repayments might not be made. We consider that this debt has been used successfully due to financial leverage the return to shareholders has increased, even if the overall amount of debt has increased.
For RA, the debt has remained fairly well constant over the last 5 years and almost equal to the shareholders’ equity, but this has steadily increased as RA has continues to invest for expansion. This implies moderate risk and may have also lead to the shareholders return have decreasing since 2003.
Short-Term Liquidity.
The short-term liquidity gives some indication of the ability of a firm to meet its debt requirements as they come due (cash must come primarily from cash or the conversion to cash of other current assets).
The purchase of new planes implies huge borrowing requirement for airlines. This huge investment means airlines have to be able to meet debt requirements to survive hence the importance we associate with this ratio.
For BA, current assets haven’t covered current liabilities over the last 5 years due to the high amount of debt. But as the proportion of current liabilities has decreased since BA began restructuring, cutting costs and stop investing after 9/11 they are almost in a state were current assets cover current liabilities.
For RA, current assets have covered, on average, 3 times their current liabilities over the last 5 years because it has performed well in the current context. But this proportion of current assets has decreased for during the last 5 years because RA hasn’t stop expanding (even if it has continued to care about the costs).
Return on Equity (ROE).
ROE measures the return on total investment in assets and ability of a firm to generate returns for the shareholder. Obviously this figure is important to any business, as without being able to generate a return to the shareholder the company will have trouble attracting further investors/shareholders.
Both RA and BA have shown varying levels of ROE since 2001 with both firms converging around the 10% mark in 2005. As mentioned already BA was heavily affected by the events of 9/11 but since then their ROE has steadily increased, whilst RA has decreased from a peak of 21.3%. Also of note, in both cases is that as percentage of debt increases (RA) or decreases (BA) so the ROE decreases or increases respectively. Further investigation suggest this most likely just to be a coincidence that can possible be explained from the cash flow statements. Here we can see BA gets a major input of cash from a ‘Sales Of Business’ (see cash flow analysis for further details).
RA’s change in direction can be explained by their need to finance their acquisition of Buzz and further plans for expansion (their investment outflow has doubled since 2001).
Cash Flow Analysis.
Cash flow management has become increasingly important after five year of industry losses. The problem is not operational. The cash raised in operations is burned later in investment and financial activities.
RA’s cash level is high due to high growth of revenues. Cash net inflows are not relevant. Cash outflows are mainly related to new fleet (140 737-800 airplanes) payments. The company is financed its investment with stock sale for E 800. As a result of this fast grow strategy, RA’s net debt and interest payments are increasing and cash net inflows are negligible.
BA’s cash increased after a reduction in 2004 due to investment divestiture. Its cash level and cash net inflow (are small compared to companies’ assets. BA cash from operations was reduced due to leases and hire purchases agreements’ payments. BA’s acquired fixed assets for L 301, sold its investment in Quantas Airlines for 2004 for L 427 M, but paid more than a billion to reduce net debt (finance leases and hire purchases) and L 240 on interests of servicing of finance (bank loans and leases)
SWOT analysis.
British airways
Strengths Weaknesses
* Cost cutting and oil management strategy were successful
* Commercial strategy to remain competitive and beat short-haul airlines
* Revenue is growing at a reasonable rate
* Debt remains high, but diminishing
* The company is investing in new airplanes
* Brand equity
* Network coverage
* Customer loyalty
* Cash flow from operations was offset by investing and financing activities
* Salaries remain high
* Operating profit is highly dependent on US market
* Increasing number of airlines operating under Chapter 11 increases competition in US, one of its main markets.
* The company is reducing investments in stock and cash to pay debt but debt remains high.
* Finance leases, hire purchases agreements and pension funds represent a financial risk
Opportunities Threats
* Terminal 5.
* Oneworld alliance’s strength.
* Industry recovery.
* Strong competition from low cost companies.
* Interest and foreign currency exchange rate.
* Fuel costs.
Ryanair
Strengths/Weaknesses
* Costs remain the lowest in the industry
* Operational efficiency represents a benchmark for short-haul airlines
* The company has won many price wars and was successful taking advantage of long-haul carriers’ capacity cuts and oil surcharges
* Major short-haul airline in Europe
* Beat easyJet competition in its home market
* Commercial short term strategy is dependent on long-haul carriers overcapacity cuts and oil surcharges
* Investing heavily via selling stock and acquiring debt
* Debt is growing fast, so the risk increases
* New airlines effect in liabilities is affecting cash flow in the present and will generate revenues until 2008
* The airline will change its fleet, so its medium term strategy has to be re-aligned to compete in long-haul flights.
* Employee relations.
Opportunities/Threats
* Other low cost airlines attrition in RA’s market.
* Purchase of new Boeings 737.
* New routes and expanded operations.
* Change in long hauls companies’ strategies.
* Oil price.
* Interest and foreign currency exchange rate.
Conclusion.
From the analysis performed we conclude the following:
BA’s and RA’s quality of earnings do not look good, but the reasons behind the cash flow to net income ratio are completely different. BA is improving rapidly, while RA is incurring in new debt to maintain its growth and we feel it’s objective to overcome BA by 2012 is excessive.
We see from an investment point of view that BA is a ‘Buy’ with good short term potential and Ryanair is a ‘Sell’ the good times are over for now.
If we were creditors or suppliers (i.e. Boeing or Airbus) we consider that loaning money to both companies in the short term is a safe bet. In the long term we would approach Ryanair with caution and would have to review their debt to net income ratio in a years time.
