Ryanair's €17bn bid to rule the skies

Ryanair's bumper order for 200 new aircraft puts it on track to double passenger numbers to 150 million within a decade. 

With rival EasyJet snapping at its heels, can it earn a decent return on this huge investment?

Ryanair's huge new aircraft order will allow it to almost double passenger numbers to 150 million by 2024. This will make the Irishairline as big as the next two largest European airlines, Air France and Lufthansa, combined. But will the new, kinder, gentler Ryanair be able to put bums on all of those extra seats and generate a decent return on the huge amount of capital that will be tied up in these new planes?

On Monday, Ryanair announced that it had placed an order for up to 200 new Boeing 737 Max 200 aircraft with a total list price of $22bn (€17bn) with the US manufacturer. This comes on top of the order for 180 Boeing 737-800s with a list price of $16bn (€12.4bn) which Ryanair placed in June 2013. These orders commit Ryanair to taking delivery of up to 380 new aircraft with a total cost of up to $38bn (€29.4bn) over the next decade.

Even for a company of Ryanair's size, with annual pre-tax profits of €591m, that seems like quite a mouthful. Have chief executive Michael O'Leary's eyes grown bigger than his belly?

Well, first things first. Monday's order consists of firm orders for "only" 100 aircraft with options over a further 100. In other words, Ryanair is committed to taking delivery of "only" 100 of the aircraft ordered on Monday. If things don't go according to plan, the options over the 100 aircraft are just that, options, from which Ryanair can walk away at no cost.

Secondly, although Ryanair never discloses the actual price it pays Boeing, it negotiates huge discounts on the manufacturer's list price. This means that Ryanair is probably committed to spending somewhere in the region of $20bn (€15.5bn) if it doesn't exercise its options and about $23bn (€17.8bn) if it does over the next decade.

Finally, Ryanair, which had a fleet of 297 aircraft at the end of March, will be offloading many of its existing planes to make way for the new arrivals. Even if all of the options are taken up, its fleet will rise to 520 by 2024. This implies that at least 160 aircraft, over half of its existing fleet, will be sold off.

Aviation is an extremely capital-intensive business. The aircraft which Ryanair ordered last week, the Boeing 737 Max 200, has a list price of $110m (€85m). Even with the sort of discounts that Ryanair typically negotiates, that's a heck of a lot of capital. The new aircraft will swell the size of Ryanair's enormous balance sheet - it had gross assets of €8.8bn at the end of March - even further.

This means that the key to long-term success in the aviation industry is achieving a higher return on capital than the cost of that capital. This is something most airlines have consistently failed to do.

A 2013 report compiled by management consultants McKinsey for IATA estimated that the world's airlines achieved a combined annual return on invested capital of just 4.1pc between 2004 and 2011. While this was up marginally on the 3.8pc annual return achieved between 1996 and 2003, it still falls well short of the sort of returns required to justify the $4trillion-$5trillion (€3.1trillion-€3.9bn) that the global aviation industry needs to invest in new aircraft over the next 20 years.

When judging an airline's underlying performance, most analysts look at two yardsticks: its operating margins and its return on capital.

Operating margins are an airline's profits as a percentage of its sales. Using this measurement, Ryanair performs quite well. It had total sales of €5.03bn in the year to March 2014, on which it earned operating (pre-interest) profits of €658m, giving Ryanair an operating margin of 13pc.

Add back Ryanair's depreciation charge of €351m and Ryanair's EBIDTA (earnings before interest, depreciation, taxation and amortisation - the measurement now favoured by most analysts) of €1.01bn was the equivalent of 20pc of sales.

These margins were well ahead of those of EasyJet, its main rival in the low-cost airline space. EasyJet's operating margin was 11.7pc in the year ended September 2013, while its EBIDTA margin was 16.7pc of total sales.

On the face of it, Ryanair is comfortably outperforming its main competitor.

Look again. While Ryanair's operating margins are comfortably ahead of EasyJet's, it's a different story when one looks at the two airlines' returns on capital employed.

A word of warning: calculating any company's return on capital is fraught with difficulty, with what constitutes capital being a source of endless disagreement in financial circles. In order to keep things simple and consistent, I have defined capital employed as a company's current assets plus its non-current assets and averaged the year-end and beginning of the year totals.

Apply this test to Ryanair and EasyJet and things start to get interesting. Ryanair's 2014 operating profit of €658m translates into a 7.4pc return on capital employed. Add back the depreciation charge and it rises to 11.4pc.

EasyJet's return on capital is significantly higher. Its 2013 operating profit translated into an 11.4pc return on capital, a figure which rises 14pc when depreciation is added back. EasyJet also had leasing charges (which are analogous to interest payments) of £102m in 2013. When these are thrown back into the mix, EasyJet's return on capital climbs to 16.3pc.

What is clear is that, no matter how one slices and dices the numbers, EasyJet is now achieving significantly higher returns on capital than Ryanair. In a capital-intensive industry such as aviation that matters. In fact, it matters a lot.

As Michael O'Leary wheels out his new kinder, gentler Ryanair, the Irish airline has been taking a number of leaves out of the EasyJet book. It has introduced a business class, it is flying to more leading airports and it has relaxed its previously ridiculously strict carry-on luggage policy.

So, with lower returns on capital than its main rival, can the huge investment Ryanair is making in new aircraft over the next decade ever possibly be justified?

"We need the new aircraft. We are number one in Europe but still have only 13pc-14pc of the market. Southwest [the American low-cost carrier on which Ryanair was originally modelled] has 25pc of the US market. The headroom exists for us to grow. The key is having the aircraft", says Ryanair chief marketing officer Kenny Jacobs.

Ryanair carried 81.7 million passengers in its last financial year. This makes it the largest airline in Europe in terms of passengers flown, ahead of Air France with 77.3 million passengers, Lufthansa with 76 million and IAG (the merged BA and Iberia) with 67.2 million. However, it is the fifth-largest airline - competing budget carrier Easyjet - that clearly has Ryanair rattled.

EasyJet flew 60.7 million passengers in the year to September 2013. This had risen by a further 6.4pc to 64.3 million in the 12 months to the end of August 2014. By comparison, Ryanair's passenger numbers grew by only 4pc to 83.4 million over the same period. When Carolyn McCall was appointed chief executive of EasyJet back in March 2010, the airline carried 71pc as many passengers as Ryanair. It now carries 77pc as many.

To grow from the 81.7 million passengers it carried in the year to March 2014 to 150 million passengers by the year to the end of March 2024, Ryanair will need to push up passenger numbers by 6pc a year for the next decade. How realistic is this? It grew passenger numbers by just 3pc in its last financial year.

As it grows passenger numbers, Ryanair has also been expanding geographically. It has submitted a non-binding bid for Cypriot flag carrier Cyprus Airways while Ryanair has also been exploring the possibility of operating routes to Moscow at St Petersburg. If either of these comes to pass, then Ryanair will find itself doing business in the Russian and Middle Eastern markets, both of which are considerably more volatile and less transparent, as well as riskier, than the Western and Central European markets in which it currently operates.

Mr Jacobs stresses that the projected growth in Ryanair passenger numbers is not dependent on either Cyprus or Russia."The modelling we have done on passenger numbers does not include either Cyprus or Russia", he says.

In practice, Ryanair is likely to concentrate most of its efforts on growing passenger numbers in Germany - Europe's biggest aviation market, where Ryanair's share is just 4pc, Scandinavia and Italy. With IATA predicting overall annual passenger growth of just 3pc in the European market, this will only be achieved if it can grow market share.

What we are likely to see over the next decade is the European aviation market following the American model with 80pc-90pc of all traffic being flown by four or five carriers, most likely Ryanair, Air France, Lufthansa, IAG and EasyJet, with legacy flag carriers such as Aer Lingus being squeezed.

"Ryanair's cost base is half of everyone else's. Why shouldn't they gain market share? The whole model is based on gaining market share", says Davy aviation analyst Stephen Furlong.

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