The London listed short-hop budget airlines were rated as ‘sell’ and ‘hold’ respectively as Berenberg, the European investment bank, initiated its coverage of six airline stocks.
Only two of the six initiations landed on the positive side as, according to Berenberg analyst Adrian Yanoshik, the airline sector is “stuck in a late-cycle mindset”.
Berenberg highlighted that whilst strong demand has boosted European airlines though this strength has been offset by higher fuel prices and labour costs, and, at the same time, earnings margins are at or above past highs.
Earnings compression is to be expected, according to Yanoshik.
Flag carriers fancied for long haul
“We forecast that the industry’s earnings (EBITDAR) margin peaked at c20% in 2017, and is set to contract by c200bp in the year to March 2019. Consensus seems to agree, with multiples contracting across most of our coverage,” the analyst said.
“However, this phase offers opportunities for investors willing to take some business cycle risk, which our analysis suggests could be mispriced.
Yanoshik added: “We find diverging supply-demand trends developing in shorthaul versus longhaul markets and expect the realisation of this trend to drive relative share performance.”
‘Buy’ rated IAG is given a 815p target, suggesting some 18% upside to the current price of 686.6p, and Berenberg believes the British Airways owner to be the only ‘flag carrying’ airline to improve operating earnings this year (and a step-up in free cash generation is anticipated the following year).
Air France-KLM, the other blue-chip airline fancied by Berenberg, is said to have the most leverage to unit revenue and, according to Yanoshik, the market is underestimating its longhaul pricing potential.
Easyjet seen as a 'sell'
Berenberg sees EasyJet as a ‘sell’, but, on the face of it Berenberg makes a superficially positive observation of the budget airline’s positioning – the bank describes that it continues to take profitable market share from higher-cost flag carriers, has high schedule quality at primary airports, and experiences less network churn compared to rivals.
Nonetheless, Yanoshik sees headwinds for easyJet into 2019 causing the erosion of its favourable position, and, Berenberg has below-consensus revenue expectations.
“Cost efforts may take longer to achieve than consensus expects. Larger aircraft will improve easyJet’s cost per seat, but its fleet transition is only occurring slowly,” the analyst said.
“Air traffic control (ATC) disruptions currently challenge any utilisation efforts, while labour market tightness makes easyJet less likely to close the gap to peers’ lower employee costs per seat.”
The analyst added: “We expect an EBITDAR margin barely half the average of Ryanair and Wizz levels. In relation to this gap, investments in holidays and digital initiatives hold uncertain margin benefits to us.
“We expect free cash generation to remain subdued by new aircraft deliveries, which could challenge easyJet’s 50% payout ratio.”
Berenberg believes that easyJet’s present valuation doesn’t reflect sufficient risk and its ‘sell’ rating comes with a 1,310p target, suggesting around 7% downside.
Ryanair not as 'cheap' as it appears
Somewhat contrasting to Berenberg’s view of easyjet, Ryanair is seen to have a weaker starting position, but, a slightly better rating.
Yanoshik sees the possibility for Ryanair to improve investor sentiment by executing collective labour agreements, albeit, the analyst also note the possibility for further workforce related volatility as labour negotiations continue and the possibility for strike actions persist.
“We struggle to find a path for Ryanair to return to FY 2018 profit levels before FY 2021,” the analyst said.
He added: “We expect lower free cash flow in FY 2019. This suggests pressure on the company’s ambitions for future buybacks.”
Berenberg forecasts a 400 basis point decline in earnings margin for 2019, with a further 200 basis points potentially eroding though 2020.
Despite this year’s clearly observed share price weakness, the bank reckons Ryanair’s valuation is still “not as cheap as it appears”, and, Berenberg’s ‘hold’ rating and €13.50 target implies only very slight upside to the current market price of €13.54.
Wizz Air set for upside
Rounding off the Berenberg’s airline initiations (elsewhere, it rates Deutsche Lufthansa as a ‘hold’), Yanoshik takes a comparatively positive view of Wizz Air (LON:WIZZ) which is seen to be building out its business from its ‘relatively isolated network’.
The analyst noted that a potential switch to debt-based fleet financing rather than aircraft leasing could create cost savings and may potentially open-up the possibility for earlier than anticipated capital returns to shareholders.
Berenberg’s valuation sees Wizz Air being ‘cheaper’ than Ryanair, though the bank believes Wizz has better growth prospects and similar margins.
With a 4,000p target the ‘buy’ rating sees some 25% upside to the current price of 3,203p.