Low-Fare Turbulence Tags Ryanair

Ryanair (RYAAY - commentary - Cramer's Take) CEO Michael O'Leary loves to insult his flag-carrier rivals for their high fares and inefficient operations. But now some of these airlines have started to make life very difficult for low-cost Ryanair. Most galling of all, government-owned Aer Lingus, the butt of many O'Leary barbs, could be snatching away passengers on Ryanair's most profitable routes.

Increasing evidence of tough competition within the European low-fare market suggests that Ryanair may never recover its once-fat profit margins. The Dublin-based airline wowed the airline world by reporting healthy profits at a time when other carriers were getting crushed by the fallout from 9/11, the Iraq war and SARS. But big flaws in Ryanair's low-cost business model, explored by this column, caught up with the company and led it to issue guidance in January that was well below expectations.

Ryanair's once-highflying stock tanked with the disappointing financial outlook, and it hasn't regained its stride since. Its ADRs were up a nickel Friday to $33.68, leaving them 42% below their 52-week high.

Ryanair was also hurt in early February, when the European Commission decided, after a lengthy probe, that a Ryanair deal with Charleroi airport outside of Brussels ran afoul of European Union government-aid rules. As a result, other airport deals that benefit from government subsidies could end up being dismantled. Ryanair would face the choice of absorbing higher airport costs, which would pressure profits, or pulling out of the airports in question, which could limit growth.

Location, Location, Location

However, the illegality of certain airport deals is actually only a minor problem for Ryanair. A bigger problem is that many of the airports it flies to are out of the way, and that limits demand to fly to them. For example, Ryanair said that it intends to stop flying its London Stansted-Charleroi route. The company said this was a response to the European Commission decision, but a person familiar with the matter says that this route showed weak revenue numbers. You wouldn't think that demand would be low for cheap flights between two of the most important cities in Europe, but it looks like Ryanair had to slash fares to an intolerably low level to get people to fly to out-of-the-way Charleroi from Stansted, which is situated north of London.

Mounting competition is just as much of a problem, and it could prevent the Ryanair recovery that many investors are betting on. One of the stupidest things any investor can do is assume that a company operating in a long-established sector can easily sustain profit margins far in excess of those of its rivals. True, new players come along and achieve great profitability, but only a few ever maintain the lead. Most see margins shrink fast when rivals catch up. And it won't be long before Ryanair's 20% operating margin slims.

Steep Drop Ryanair trades near lows

In explaining the soggy outlook for 2004, O'Leary said: "There is ... considerable downward pressure on fares and yields as many of these loss-making airlines try to compete and survive. In many cases Ryanair is leading the downward pressure on prices and yields, but unlike our competitors we continue to generate world-leading profit margins as a result of our aggressive cost management and lowest cost base." (Yield refers to revenue per passenger, and a drop in fares obviously reduces it.)

Well, we'll see if Ryanair continues to generate the "world-leading profit margins." A good place to start to assess whether it can is the heavily flown Ireland-U.K. routes. These make up an inordinate share of Ryanair's overall business. ABN Amro analyst Andrew Lobbenberg calculates that in the 12 months ended March 31, 2003, the Ireland-U.K. market accounted for 36% of Ryanair's revenue and at least 40% to 50% of profits (if the routes have above-system profitability).

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to [e-mail].