Value in easyJet altitude drop

Arguably this is a contrarian view, especially as sentiment has clearly soured since easyJet’s shares reached peak altitude in June. Air traffic control strikes, IT costs, fierce competition and anticipated losses on slots it acquired from the collapsed Air Berlin have been compounded by the broader sell-off in UK blue-chip stocks. And for all the talk of robust demand, many investors will fear the airline’s exposure to potentially nervy UK consumer spending, even if bosses are clear that an Austria-based air-operator certificate should shield the group from whichever form Brexit takes.

Either way, the stock appears to have grounded, having fallen 40 per cent since the summer. We think this has created a buying opportunity, particularly when viewed against results for the year to September 2018. Those numbers detailed a 16.8 per cent rise in revenue and a 6.4 per cent increase in revenue per seat to £61.94, which drove a 29 per cent uptick in headline profit per seat to £6.07. And while costs came in above initial forecasts – including £40m incurred in the Tegel slots acquired from Air Berlin and £65m from “a change in approach to IT development” – the result of easyJet’s investments was a rise in headline return on capital employed from 11.9 to 14.4 per cent. In turn, this led management to lift the full-year dividend by 43 per cent to 58.6p, which will be paid at the end of March to those on the register at the end of February.

The 5.5 per cent yield positions easyJet's shares as an income play, and management's bullishness should also be seen against a looming abatement in cost pressures. For one, the price of jet fuel, which made up 22 per cent of the company’s overheads last year, has dropped by around a quarter since September. This should help to offset the rising cost of the airline’s emissions trading system permits, even after management hedged 65 per cent of this year’s fuel costs at $571 a tonne – a full 14 per cent lower than last year’s average market price. Still, the time delay hedging brings means the group expects a £50m to £100m fuel headwind in the current year before the benefits come through. The gradual conversion of easyJet’s fleet to the Airbus A321neo, which began in July, should also help, and is expected to reduce both fuel burn and carbon dioxide emissions by 15 per cent.

Another big factor outside of easyJet’s control is the strength of the dollar against the pound and the euro, which most forecasters expect to continue in 2019. Fortunately, two-thirds of easyJet’s dollar exposure for the current year has been hedged at $1.33 per pound.

The other big risk for the airline is industry overcapacity, a point demonstrated by easyJet’s own plans to expand by 10 per cent this financial year. Despite signs of “promising” booking numbers for summer 2019 and a drop in capacity growth last year due to the failure of some rival airlines, such as Alitalia and Monarch, this has contributed to management guiding that first-half revenue per seat “is expected to be down by low to mid single digits”.

However, prospective investors should bear in mind that this issue is likely to affect all European airlines, and the strength of easyJet's business has seen it prosper from the woes of others in the past. It has a cash-rich balance sheet, a well-developed network of slot-constrained primary airports, and a strong market standing. The latter point is demonstrated by its rating as the number one “low-cost carrier in value for money perceptions in all of its core markets”, according to brand consultancy Millward Brown.

Still, given the big constraints on capital, you wouldn’t buy a share in easyJet merely for its brand. So what’s the group worth? According to analysts at Liberum, fair price for the stock amounts to 1,350p, based on one times enterprise value to invested capital, divided by return on invested capital to weighted average cost of capital (ROIC/WACC). Another metric to look at it might be a comparison of rolling next 12 months price/earnings (PE) ratio of 9.2 to the long-term average of about 12 (11.9 over five years, 12.2 over 10 years). Meanwhile, the enterprise value to forecast cash profit (EV/Ebita) ratio of 4.5 compares with a 10-year average of six.