Monday 22 January 2018

Despite dividends, investment in airlines still comes with a serious health warning

SOME investors take a punt on airlines for the thrill of living on the edge, flirting with wild returns' volatility in the hopes that they'll have the skill to get in and out at opportune times and pocket a windfall.

Others invest in airlines because they harbour the (misguided) belief that a rapidly growing, immensely profitable company like Ryanair must be a good place to stick some money.

One thing that hasn't been a traditional motivation for airline investment is dividends, because airlines simply didn't pay them (or not in any meaningful way).

The business of putting $40m planes in the air is horrendously capital intensive and the cyclical nature of airline earnings means companies often need a cash cushion to take them through the quieter months of the year when costs can't fall as much as revenue.

As Ryanair chief Michael O'Leary often used to put it, if you want a dividend, go invest somewhere else.

Last week, though, Aer Lingus became the latest in a long line of airlines to return cash to its shareholders, bowing to pressure from (ironically) Ryanair or the Irish Government, or trying to ingratiate itself with the markets, depending on whose version of events you believe.

On the face of it, Aer Lingus was only treading where Ryanair had already gone, after Mr O'Leary's airline handed back €500m to shareholders in a special dividend in 2010 and indicated it was likely to make another exceptional payout for 2011's results.

But Aer Lingus's strategy was subtly different. Instead of going down the 'special dividend' route chosen by Ryanair and easyJet (which announced a £190m payout late last year, largely made up of a 'special' dividend), Aer Lingus offered a dividend dismissed as "paltry" by Ryanair, but also it was committing itself to "on ongoing sustainable dividend policy".

In other words, Aer Lingus is positioning itself as an income stock, where investors can depend on a regular flow of cash rather than having returns that are entirely at the mercy of prevailing share prices.

A look at airline share price gyrations shows why Aer Lingus is keen to take more control over the returns investors might enjoy/suffer. Southwest, one of the industry's most consistent performers, suffered a 29.3pc share price fall in 2008, enjoyed a 32.5pc rebound in 2008, rose 13pc in 2010 and promptly dove 34pc last year. Fasten your seat belts and all that . . .

Aer Lingus isn't an outlier in pledging 'sustainable' dividends. US low-cost carrier Southwest (seen as many as the forerunner for Ryanair), has been paying quarterly dividends since 2001. Their dividends are positively tiny and give a yield of just 0.22pc based on the stock's prevailing price of circa $8.20. Aer Lingus's dividend yield will be about 3pc, if the airline continues to trade close to the €1 mark.

Closer to home, Lufthansa has been a long-running dividend enthusiast with a target dividend payout ratio of 30 to 40pc, implying that about a third of its profits are handed over to shareholders each year. For the 2011 year, Lufthansa said it was making a "departure" from its dividend policy by handing out money to shareholders, even though the airline made a net loss of €116m, so keen was it to woo investors with the regular cash returns.

Not every airline is embracing the growing dividend fad -- Air France for example, has an "objective" of a sustained dividend policy, but has made zero payouts in recent years.

Meanwhile, IAG -- the mega-airline formed by the merger of British Airways and Iberia -- boasts a "shareholder discount scheme" -- ie, cheap flights -- for original British Airways shareholders and IAG says it's "evaluating" the merits of extending this to stockholders who originally held Iberia.

Dividends decrease the volatility of airline returns and may increase the absolute returns for stocks that are fundamentally mispriced by imperfect markets. Lower volatility is welcomed by most investors (save the thrill seekers) and higher absolute returns are universally welcomed.

But despite the increasingly present dividend gravy train, airline investment still comes with a serious health warning.

Oil prices are rising, and oil prices make up a massive amount of airlines' costs (33.8pc of Ryanair's total costs in 2010, and 22.4pc of Aer Lingus's, according to Bloomberg data).

The onward march of European high-speed trains and other social changes threaten demand, as do carbon taxes and the continuing recession (though low-cost carriers have won some ground here, boosting their share of Europe's short-haul market by 3.3pc last year)

The current valuations of our airlines should also give would-be investors pause for thought. Ryanair, which will soon report results for the year-ended March 2012, trades at a price to earnings ratio of 12.6.

That means its share price is roughly 12.6 times its current earnings per share, making it look expensive compared to Aer Lingus's P/E ratio of 7.3 and IAG's 7.1 (Though more in line with Lufthansa's 11.3, Southwest's 11.97 and US Airways' 10.57.)

Ryanair's 'price to book' -- the ratio of its share price to book value/assets per share -- tells a similar story. Ryanair has the second highest price to book, coming in at 2.0 against easyJet's 1.3, IAG's 0.8, Aer Lingus's 0.6, Lufthansa's 0.6 and Air France KLM's 0.2.

One view is that the market is betting Ryanair can put its assets to better use than the other airlines -- a view borne out by the airline's consistent ability to outperform its peers on virtually all performance metrics. Another view is that Ryanair's share value is simply too high, that while there should be a premium for Ryanair's superior management, the premium is too great.

Then there's the airlines' recent share price performance. Ryanair is up 20pc in the last year, continuing an upward trend they began after a low point in October 2008. Their current trading (in the 4.20 to 4.45 band since late January) represents the best price the stock has enjoyed since mid-2007.

Aer Lingus is up 15pc in the past year. Supporters say it has more to go if a recent 3pc investment by Middle Eastern carrier Etihad leads to anything more material; sceptics say failure to do more with Etihad could lead to a share price slide.

A final thought: despite the progressive addition of dividends, European airlines' total returns have been overwhelmingly negative for the past five years. Ryanair has the distinction of having being the best performer, with a total return of -24.37pc, while Aer Lingus's total return is -76pc, Air France's -87pc and easyJet's is -48.32pc.

Dividends can only cushion so much.

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