Aviation regulation is up in the air as the clock ticks closer to March 2019 when the UK will leave the European Union. This deadline has airline bosses worried about what will happen if, in the case of a hard Brexit, the UK leaves without a deal. Some have warned that if an agreement is not reached in time, flights between the UK and the EU would be grounded. While this may unintentionally solve the immigration question, it could be bad news for the airlines’ shareholders.
One of the perks of being part of the EU is the ability to operate flights freely between member states through the ‘Open Skies’ contract. The UK will no longer be part of any EU-related agreements post Brexit and, while many other industries can revert back to the World Trade Organisation (WTO) rules, the aviation industry has no historical agreement to fall back on.
London-listed airlines that have routes within the EU also run into the issue of ownership laws. Any airline that wishes to operate flights within the EU must show that it is owned and controlled by EU nationals with the requirement to prove that at least half of its shares are held by EU-member citizens.
Taking flight
Carolyn McCall may be on her way out the door from her role as chief executive of easyJet (EZJ), but she has left the company well prepared to deal with whatever outcome may arise from Brexit negotiations. The budget airline received its Air Operator Certificate from Austria’s Federal Ministry for Transport, Innovation and Technology last month, which allows it to establish easyJet Europe. This new subsidiary is headquartered in Vienna and gives easyJet the ability to continue to operate flights both across Europe and domestically within European countries after the UK has left the EU, regardless of the outcome of discussions about a future UK-EU aviation agreement. The people and planes that will operate the new easyJet Europe business are already all in and employed in Europe.
This air operator certificate will cost easyJet up to £10m over the next three years once all the aircraft registration costs have been totalled up, and around £3m of this has already been paid during the 2017 financial year. Close to a third of easyJet’s network of flights fly within and between EU member states, so it looks set to be well worth the cost over the long term.
Experiencing turbulence
Ryanair (RYA) chief executive Michael O’Leary isn’t one to mince his words, and the UK’s departure from the EU has been no exception. Mr O’Leary’s disdain for Brexit began well before voters cast their ballots, and he was a vocal ‘remain’ campaigner. Now that the UK is in the process of figuring out on what terms it will proceed with its ‘divorce’, the chief executive has warned that Britons’ summer holidays in 2019 could be on the line if a concrete deal isn’t in place before the end of 2018 (this being when airlines start scheduling and selling flights for the following summer period).
A spokesperson for Ryanair said it “remains concerned at the uncertainty which surrounds the terms of the UK’s departure from the EU” in March 2019. While the company continues to campaign for the UK to remain in the EU Open Skies agreement, the representative cautioned that should the UK leave, there may not be sufficient time or goodwill on both sides to negotiate a timely, replacement bilateral agreement. This could result in the disruption of flights between the UK and the EU. If Ryanair doesn’t have certainty about the legal basis for operating flights by the autumn of 2018, it could be forced to cancel flights and move some or all of its UK-based aircraft to continental Europe as of April 2019. The spokesperson added that the airline has “contingency plans in place” and will adapt to “changed circumstances in the best interests of our customers and shareholders”.
International Consolidated Airlines (IAG) has a slightly more optimistic approach to Brexit plans. A representative said IAG will continue to comply with the relevant ownership and control regulations but added that the company is “confident that a comprehensive agreement between the EU and the UK will be reached”. IAG believes it is in Europe’s interest to have a “fully liberalised aviation agreement” as 900m travellers fly between the two regions each year. “That not only benefits customers but creates jobs and wealth across the continent,” the spokesperson said.
Wizz Air (WIZZ) is not letting the prospect of a hard Brexit get in the way of its plans to add a million seats to its UK operations on top of the million it added during its last financial year to March. As the largest low-cost airline in central and eastern Europe, the company is thinking that weak sterling could attract higher numbers of tourists to the UK to take advantage of their improved spending power. Chief executive Jozsef Varadi said at the full-year results in May that there were “no signs of demand weakness” on flights to and from the UK. Although weak sterling resulted in a €17m (£15.4m) negative translation effect this was largely offset by the rest of the group’s diverse network of routes, and thus revenue.
The Budapest-based airline is taking the reverse approach to easyJet when it comes to Brexit. It’s planning to apply for a British air operator certificate so that it can continue to fly between the UK and the EU in the case that no aviation deal is reached in time. Mr Varadi thinks it looks “increasingly likely” that Brexit negotiators will not come to an early agreement on aviation, and so the British air operator certificate should help protect the interest of both Wizz Air’s customers and investors.
Ownership headwinds
IAG chief executive Willie Walsh took a more cautious tone when he met with the European Parliament last month. He urged members to overhaul EU ownership laws so that UK nationals would still count towards the 50 per cent threshold of shares that have to be owned by EU nationals. The owner of British Airways and Aer Lingus would not reveal the proportion of shares held by EU citizens not including UK shareholders, but estimates from analysts suggest that the group would certainly fall below the threshold. This could force the group to spin off part of the business or to buy out up to a quarter of its shareholder base.
Ryanair could also face problems with ownership requirements. Currently, the airline’s share ownership is split 54 per cent EU owned and 46 per cent non-EU, although 20 per cent of the total figure is in the hands of UK shareholders. A spokesperson stated that if UK owners of Ryanair’s shares are no longer designated as EU nationals, then the company may have to take action to make sure that they can meet compliance. Ryanair’s articles of association give the company certain powers to ensure that the number of ordinary shares held by non-EU nationals does not reach a level that could jeopardise the airline’s entitlement to continue to hold a licence that enables it to carry on business as an air carrier. Some institutional shareholders may decide to re-domicile their investments, but others could risk becoming disenfranchised and, in some instances, be required to sell their shares.
Favourites
Shares in Wizz Air are up 23 per cent since our buy tip in June. Of all the airlines discussed, Wizz Air looks best placed to deal with Brexit. The airline looks set to benefit from its exposure to central and eastern Europe as weak sterling could encourage more people in the region to travel to Britain. Wizz Air is continuing to increase its capacity, with available seat kilometres up 20 per cent during the 12 months to March, while continuing to fill more seats. At 2,842p, the shares are trading at 14 times forward earnings, which still looks reasonable given the scope for growth.
We also like IAG for its diversified and large-scale business. It owns a number of different airlines across all budgets, from British Airways to Aer Lingus to Vueling. The company reports in sterling and so benefited from the more favourable exchange rate at the last set of results. And yet, at 619p the shares are trading at just six times forward earnings, a clear discount to other London-listed airlines.
Outsiders
At the end of last month, we downgraded our view on easyJet after it said higher capacity could begin to weigh on yield. Analysts have also warned that free cash flow could fall as the airline looks to spend more on capital expenditure, which could put the dividend at risk. The 16 times forward earnings rating make the shares look expensive compared with their historical valuation and to sector peers. We see little reason to offload the stock altogether, but this looks like a pricey entry point.
Ryanair looks like it could be in a similar situation. In May, management warned that the combination of weak sterling and excess capacity in Europe could push down average fares by between 5 and 7 per cent in the year to March 2018. Ryanair is focusing on routes in Europe and has reined in expansion plans for the UK in light of Brexit, although this could be a waste of effort if it is eventually forced to ground flights on the continent. Its shares are trading at the upper end of their historical valuation at 15 times forward earnings, so this looks like an expensive entry point for would-be investors.
The analyst's view
As an airline that derives a large proportion of its revenue from the EU, the issue of Brexit is clearly a very significant one for easyJet. At the time of the referendum, the company said it was confident that Brexit would not have a material impact on its ability to deliver long-term sustainable earnings growth, but Carolyn McCall said she was keen for the UK to remain part of the single EU aviation market.
Since then, the company has taken sensible steps to address the uncertainty over the final negotiated deal between the UK and the EU by getting approval for an air operator certificate and an airline operating licence in Austria, which will enable it to continue flights between EU countries and within them. The shares have outperformed the market so far this year, in common with several of its peers, although the main challenges faced by easyJet relate more to excess capacity, fierce competition and the uncertainty created by the departure of Dame Carolyn than Brexit.
But it’s true that, at the moment, there is some uncertainty. The company is looking for a chief executive and faces fierce competition from Ryanair. It should worry to a lesser extent about IAG – it doesn’t face the same level of rivalry given the latter’s legacy business. EasyJet does have a strong balance sheet, but issues with the cost base and capacity will make progress a little more difficult in the near term. Once it has a new chief executive in place, the capacity plans are made clearer and the competition threat manifests one way or another, the investment case should be stronger.
Ultimately, there’s a limited amount easyJet can do to address Brexit at this time, which only increases the level of uncertainty and risk. Once we get a feel for where the wider political negotiations are going and how final agreements will look, it will be easier for investors to understand how the business will act moving forward.
Ian Forrest is an investment research analyst at The Share Centre
