Ryanair and IAG are picks of the bunch as European airline valuations become cheaper

The European airline sector is having a tougher time in 2016 after a bumper summer in 2015. But the fall in share prices means stock valuations are looking relatively cheap, meaning it could be an opportune moment for investors to look again at the sector.

Europe’s airlines, particularly its budget carriers, had a bumper summer in 2015, but a year later and the sector is facing a host of issues including a terror-related hit to demand, the impact of numerous strikes, pressure on ticket prices and rising fuel prices.

That’s not to say it’s going to be a bad summer for the airlines, but it’s unlikely to be as good as the last one.

Take UK-based airline easyJet as an example. When the budget carrier released its interim results in May, it said forward bookings for the key summer months were in line with last year and it was 'well placed to grow revenue and profit this financial year'. That all looks positive and yet its shares are down 18.4% so far in 2016, underperforming a 2.7% decline in the FTSE 100. That’s because the end of flights to Sharm el-Sheikh in Egypt and the impact of the Paris terrorist attacks has hit its revenue per seat. It’s not expecting a recovery until the July to September quarter.

Over at Ryanair, it’s a similar story. Last month it reported a 43% rise in net profit and a 16% rise in revenue for its last financial year. Traffic jumped again in May as it continued to add new routes. But Europe’s largest low-cost carrier said it suffered over 500 cancellations following the terrorist attacks in Brussels, while strikes in Italy, Greece, Belgium and France had caused a further 200 cancellations. It has consistently warned about pressure on fares and has pledged to lead the price war in the budget sector. Its shares are down 12.6% so far this year.

The airlines are able to pay for the drop in fares because they’re paying much less for their fuel. These offset each other. It’s the strikes and the terrorism impact that’s hurting them. Last summer was relatively incident free, and both Ryanair and easyJet raised their profit guidance twice in 2015 as demand from sun-seekers in northern Europe boomed and fuel prices fell.

The recent rise in oil prices, from about $30 a barrel in mid-January to almost $50 a barrel now, isn’t good news. In fact, some of the weak performance in airline stocks so far in 2016 can be attributed to the increase in oil prices. However, airlines hedge a large proportion of their fuel needs, and that means it will take time for the price rise to feed through. When it does, airlines are likely to raise ticket prices to compensate.

It’s not just the budget carriers facing a tougher summer than in 2015. The long-haul carriers are not immune. Airline demand tends to be closely correlated with how well an economy is doing, and the global economic outlook has clouded over the past year as growth in China has slowed, low commodity prices continue to hit resource-rich countries and emerging markets like Russia and Brazil remain mired in economic doldrums. Even Japan and the eurozone are struggling to lift moribund economies.

International Consolidated Airlines Group, which owns British Airways, Spanish airlines Iberia and Vueling and Ireland’s Aer Lingus, has had a good few years as it has reaped the cost benefits of restructuring first BA and then Iberia. Its issues now are the impact of terrorism fears and potential weakness on some routes due to the economic situation. Earlier this month, analysts at Barclays cut its price target on the stock because they think US, Chinese and Japanese demand could be weak for the rest of the year. IAG shares are down nearly 20% so far this year.

Over at Air France-KLM, the situation is worse as the French part of this airline group is worst hit by strikes. Its pilots, which have been resisting the restructuring efforts of management for years, have gone on strike again, prompting criticism from KLM. Air France is still running between 75% and 85% of its flights, but the strike will cost it at least €30 million and could impact forward bookings. Its shares are down 8.7% so far in 2016, although the stock has been lagging peers for some time.

Germany’s Lufthansa is also trying to catch up with IAG in terms of restructuring. It needs to trim its cost base, and has suffered strikes by both pilots and cabin crew. The airline is winning, with unit costs down by 4% in the first-quarter, but this is an ongoing process and won’t be helped by the recent surprise exit by the chief financial officer. Its shares are down 22% so far this year.

It’s not all bad news for European airline investors. Stock valuations were lofty before the recent sell-off. They looking a lot more fairly valued now, and the long-haul carriers look relatively cheap. On a blended forward price-to-earnings valuation, Air France-KLM trades at 3.0 times, IAG at 5.3 times and Lufthansa at 4.1 times. Historical averages are much higher. Low-cost carriers Ryanair and easyJet are a bit closer to historical averages, at 11.1 times and 8.9 times, respectively.

This drop in stock valuation has turned analysts more positive on some of the stocks. The last three ratings changes for easyJet, for example, have been upgrades. Ryanair, easyJet, and IAG are the pick of the European airlines according to analysts. Seven have Ryanair at 'Strong Buy', ten at 'Buy', four at 'Hold', and just one at 'Sell', according to data compiled by Thomson Reuters. Seven analysts also have easyJet at 'Strong Buy', nine at 'Buy', seven at 'Hold', one at 'Sell' and one at 'Strong Sell'. Eight have IAG at 'Strong Buy', 11 at 'Buy', four at 'Hold' and none at 'Sell'.

Analysts are more mixed on Lufthansa and Air France-KLM, reflecting the risks associated with the ongoing restructuring at the two airline groups. Four analysts have the German airline at 'Strong Buy', two at 'Buy', 12 at 'Hold', seven at 'Sell' and three at 'Strong Sell'. Three analysts have Air France-KLM at 'Strong Buy', five at 'Buy', 10 at 'Hold', six at 'Sell' and three at 'Strong Sell'.

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