Ryanair still a hold

Croesus/An insider's view of the market: Ina nervous market, any company that issues a profit warning can expect to see a sharp fall in its share price. Rarely out of the headlines, Ryanair's third-quarter results gained far more airtime that its spat in France with president Sarkozy and his new wife, as the company revealed that Q3 profits (to end-December) had fallen sharply.

The headline number was the 27 per cent decline in profits adjusted for an exceptional profit of €12.1 million from the sale of five Boeing- 737-800 aircraft, and a €10 million cancellation penalty from a previous hotel partner. A decline in Q3 profits was widely expected and the figures were accompanied by guidance from the company that Q4 (to end-March 2008) earnings would be in line with earlier guidance of €470 million, up 17 per cent on the previous year.

Chief executive Michael O'Leary was refreshingly frank on prospects for next year. On Ryanair's most optimistic assumptions, profits could grow by 5 per cent to €500 million in fiscal year 2009; its most pessimistic assumptions see an outcome where profits could fall by up to 50 per cent.

The assumptions underlying these scenarios were set out, with the most important variables affecting profits being:

• The oil price and the euro/dollar exchange rate;

• Yields, ie average fares per passenger;

• UK consumer confidence and the euro/sterling exchange rate.

The optimistic 5 per cent profits growth projection relies on a scenario where yields remain flat and the oil price drops to about $75 per barrel. The pessimistic scenario is based on the forward oil price remaining at the current level of $85 per barrel, combined with weak consumer sentiment and sterling weakness.

Developments in the UK, where approximately 50 per cent of profits are generated, are particularly important and current indications are that a sharp slowdown in consumer spending has already occurred.

In the past Ryanair has reacted to weak demand with big fare reductions and the company has made it clear that it will continue with this policy.

Therefore, Ryanair would continue to grow the number of passengers carried, but the average fare would decline. As a rule of thumb every 1 per cent decline in yield leads to a 5 per cent decline in earnings. Ryanair's pessimistic scenario sees a 5 per cent decline in yields that would result in a 25 per cent hit to profits.

A fall-off in demand in the UK and in Europe as global growth slows seems inevitable. But Ryanair's competitors' response will also have an impact. Many airlines, particularly those that are financially stretched, are likely to cut back on capacity growth this year. Less competition should lessen the size of Ryanair's fare cuts, thus softening the blow to profits.

The other key swing variable is the oil price, where analysts estimate that a $5 per barrel move results in a 12 per cent move in earnings. For the 2008 financial year, Ryanair benefited from some astute hedging at $65 per barrel. From April the company will be unhedged and therefore profits will be at the mercy of the oil market. Nevertheless, an unhedged position looks to be a better tactic than to hedge at the current elevated oil price.

If the US suffers a recession this year, with the knock-on consequences for global growth, the oil price will almost certainly fall. In this scenario the hit to profits from weaker demand would be partially offset by a lower oil bill.

Ryanair's worst-case scenario seems most unlikely and a modest fall in profits looks most likely next year. Beyond the media hype, the share price has behaved in a way that reflects this more sanguine view of events. Last week the price traded above €3.80. After the results announcement it fell sharply but is currently trading at around €3.55. This market reaction indicates that investors are taking on board tougher trading conditions ahead, but are prepared to continue to back Ryanair's long-term growth story. Croesus goes along with this assessment and takes the view that the best airline stock to hold in any portfolio continues to be Ryanair.