A debt-laden airline that won't meet its sky-high ambitions

And while it was obviously not management’s intention for Wizz Air (WIZZ) to deliver a sub-par performance as it attempted to race out of a period of pandemic-linked disruption, to many of its UK customers things must have seemed pretty broken last summer. 

Wizz was the worst major airline in terms of delays for UK flights for the second year running in 2022, according to the Civil Aviation Authority (CAA). In the third quarter, it racked up twice the level of complaints received by any other major airline and it was rebuked by the regulator in December for not dealing with them quickly enough. The CAA described delays in settling outstanding county court judgments awarded to customers as “unacceptable”. A spokesperson for the airline said it has since paid, or arranged payment, on 80 per cent of these judgements and is working to get the court registry updated to reflect this.

Wizz Air admittedly faced more significant challenges than many of its competitors last year. Given its roots in central and eastern Europe, it was perhaps the worst affected of the low-cost carriers by the war in Ukraine. It had to reshuffle “around 11 per cent of our capacity from Ukraine and Russia to other new markets”, chief executive József Váradi told analysts on an earnings call last week. It also faced both supply chain and labour shortages, which meant that at the peak of disruption in June last year around 4 per cent of its flights were cancelled.

Costly delays

Moves to put this right go some way to explaining why, despite more than doubling revenue to €3.9bn (£3.3bn) for the year to end March, Wizz still declared an operating loss of almost €467mn, in line with the previous year. Net other expenses increased by 166 per cent to more than €141mn and €111mn of this was attributed to the cost of flight cancellations and delays. Wizz has since spent more than €100mn on improving operational resilience, increasing the number of spare aircraft available and creating “a robust standby system for pilots and cabin crew”, says Váradi. Wizz took on an additional 2,500 staff last year, pushing the number of total employees to almost 7,400. It expects this to exceed 8,000 by the end of the current financial year.

Even with this additional overhead, the company is forecasting a swing in profitability of nearly €1bn this year, turning from a net loss of €535mn to a guided profit range of between €350mn and €450mn. Management expects to achieve around €400mn of this through revenue improvement as Wizz increases frequencies on more established routes. Routes less than three years old rose to 44 per cent of the total last year due to the redeployment of Russian and Ukrainian planes and crew, but this figure should fall to 37 per cent this year.

Around €200mn of profit is expected to come from a reduction in costs per seat kilometre flown as fleet utilisation improves and it faces less disruption to schedules. The remaining €400mn will be generated through what Váradi terms a “blend of the macros”, including lower jet fuel prices and more favourable foreign exchange rates.

Meanwhile, some of the headwinds faced last year are likely to become tailwinds and Wizz’s expectation seems reasonable that it will take more market share from flag carriers struggling with higher overheads, including steeper interest charges on hefty debt burdens.

It still has the second-lowest cost base in European aviation behind market leader Ryanair (IE:RYA), and Váradi says airlines have been able to pass through higher costs and increase yields in what he describes as a “more benign revenue environment than ever before”.

Yet given the huge growth in capacity by 2030 that management plans, there are questions as to how sustainable its outlook for improved yields will be. It grew capacity (measured by available seat kilometres) by 76 per cent in 2022-23 to 40 per cent above pre-pandemic levels. It plans to add a further 30 per cent this year, and to continue growing capacity by 15-20 per cent each year until 2030, by which time its current fleet of 179 planes will have increased to 500. The company believes it can continue to deliver a net income margin of 13-15 per cent a year while doing this, which seems ambitious. Although it would be harsh to judge Wizz on the past three years given the global pandemic, it only achieved that margin in three of the preceding nine years, according to data provider FactSet.

Stretched balance sheet

And although its strategy of leasing rather than buying planes means it will not have to shell out large sums in capital spending, it will also mean that Wizz incurs more liabilities on what is an already-stretched balance sheet.

The airline, whose debt was downgraded to junk status by Moody’s Investors Service in November, finished the year with net debt of €3.89bn, which was 29 times its cash profit. Improved earnings this year should help to lower that ratio, but the scale of its obligations even before new leases kick in highlights how important it is that the company continues to deliver profitable growth.

To do this, management is banking on an eastward expansion through a joint venture with state-owned investment company ADQ in Abu Dhabi and an agreement signed (although the scope is not yet finalised) with Saudi Arabia’s Ministry of Investment for a joint venture in the kingdom.

Yet as analysts at HSBC pointed out in April, profit margins in the Middle East “are likely to be quite depressed”. Wizz enters the UAE market as only the fifth-biggest player, and there are two well-established local budget airlines in Air Arabia (AE:AIRARABIA) and Emirates-owned Flydubai. Wizz has been offering fares that are 50 per cent lower than the incumbents in a bid to win market share but, since it doesn’t break out the joint venture’s performance, it is difficult to gauge the potentially dilutive effect this could have on margins, said HSBC's analysts.

Mind the gap

Heading eastwards at least means Wizz avoids direct competition with Ryanair. Dublin-headquartered Ryanair claimed in its recent results to have widened its lead over Wizz as Europe's lowest-cost operator. HSBC's analysts say that when the pair compete head-to-head, the hit to Wizz’s yield is typically greater than that faced by Ryanair.

Both airlines recently expanded in Italy following the eventual collapse of the country's perennially lossmaking former flag carrier Alitalia. But Wizz has since closed regional bases in Palermo and Bari to focus on Rome and Milan, from which it can avoid direct competition with Ryanair by serving connecting routes to the Gulf. Wizz now claims a 10 per cent share of the Italian market, making it the fourth-biggest player. Ryanair is now the biggest, having taken a 40 per cent share.

With Ryanair also recently signing a new 300-plane order with Boeing (US:BA) – which should take its fleet size to 800 by 2034, excluding replacements – avoiding direct competition will become much more challenging.

There is an argument to be made that having so many planes on order should be seen as a plus point for Wizz, particularly as it could take manufacturer Airbus (FR:AIR) nearly a decade to clear its order book at current production rates. If Wizz can make a success of its Middle East ventures, it could become a target for a Saudi Arabian government that needs to source planes for the new national airline it is planning to build, says Dudley Shanley, an analyst at stockbroker Goodbody. Yet investing in a company in anticipation of a bid is rarely a good idea, and the 49 per cent year-to-date gain in Wizz’s share price means that recent broker upgrades following last week’s upgraded guidance look priced in.

On face value, the shares don't look too expensive, rated at around 11 times the average of analysts' earnings forecasts for 2023-24, according to FactSet. But a lot needs to go right for those forecasts to be hit, such as fuel costs remaining low. Besides, over the longer term, the doubts we have about Wizz's ability to achieve the margin targets it has set while rapidly expanding its fleet mean the risks are skewed towards the downside. Sell.