Cube UK report (17 May 2021) – Ryanair flies high on recovery hopes

Cube UK report (17 May 2021) – Ryanair flies high on recovery hopes

Good morning, it’s Roland here with today’s Cube UK share report on 17 May.

Today hopefully marks another step back towards normality here in the UK, with restrictions on many indoor activities and overseas travel eased. The two companies I’m going to look at today have had varying experiences during the pandemic — do either of them look attractive at current levels?

  • Ryanair (RYA): full-year results from the Irish budget airline
  • Diploma  (DPLM): this engineering and science group has issued strong half-year results, with a “significant upgrade to full year guidance” 

Ryanair

  • Stock data should display here.
Market cap £16.0bn
RNS Final results
Writer disclosure No position

From today, UK residents will be able to take an overseas holiday without incurring a £5,000 fine, subject to the conditions imposed by the traffic light system. Ryanair boss Michael O’Leary believes that if the successful rollout of vaccines in Europe continues, “we can look forward to a strong recovery” in fiscal H2 (September 2021 – March 2022).

Mr O’Leary will certainly be hoping that he’s right — Ryanair reported its biggest ever loss last year. Here are the headline figures from the airline’s results for the year to 31 March:

RYA FY21 highlights

The numbers speak for themselves. Despite cost-cutting, government furlough support, and savings from grounded aircraft (e.g. fuel), Ryanair’s operating costs only fell by 66% last year, compared to an 81% fall in revenue.

Although no airline can be expected to remain profitable when faced with an 81% drop in passenger numbers, I think today’s numbers are useful, if extreme, demonstration of operating leverage. For companies with high fixed costs (like airlines), a small change in revenue results in a bigger change in profits. When revenue is rising, this is good news. When revenue falls, profits can rapidly collapse.

Beyond this, I don’t think there’s much to learn from last year’s numbers. They represent a unique situation in the history of air travel, and one that hopefully won’t be repeated for the foreseeable future.

I’m confident Ryanair can return to operating profitably. The two questions investors must ask, in my view, are whether the company’s balance sheet and equity valuation make the shares worth buying. Let’s take a look at each of these.

Debt/Liquidity: Ryanair’s net debt rose from €403m to €2,277m last year. This reflects an increase in gross debt and a fall in gross cash. Looked at another way, net debt represents around 27% of fixed assets. That looks reasonable to me at this low point in the cycle.

Net debt would have been higher, but Ryanair sensibly raised €400m through an equity placing in September 2020.

Today’s accounts show available liquidity of €3.15bn at the end of March. I would guess that this will be enough to allow a return to normal operation without any further increase in gross debt.

On balance, I think Ryanair’s balance sheet looks relatively healthy at this time. The group’s leverage situation would not discourage me from owning the equity.

Ryanair valuation – My view

For what little it’s worth, I agree with Michael O’Leary. It may take another year, but I think air travel will make a strong recovery over the next 12-18 months.

However, Ryanair’s share price suggests to me that a strong recovery is already priced into the stock. The group currently has a market cap of around £16bn and an enterprise value (market cap plus net debt) of around £18bn.

According to historic data on Stockopedia, the equivalent figures at the start of 2020 were a market cap of £14bn and an enterprise value of £14.4bn.

In other words, like many leisure and travel businesses, Ryanair is valued more highly today than it was before the pandemic. This doesn’t make sense to me, especially as markets were pretty bullish in Jan/Feb 2020.

What can we expect? The latest consensus forecasts I can see suggest Ryanair will report an FY22 net profit of c.€100m. I’d see this as roughly breakeven.

The business is then expected to start firing on all cylinders in FY23 (April 2022 – March 2023), with an after-tax profit of €1.5bn. At the current share price of €17.20, that puts Ryanair on around 13 times FY23 forecast earnings.

I don’t see any reason to pay upfront for a recovery that’s likely to take a couple of years. Although I think the group’s low-cost, standardised business model is probably a good way to run a profitable airline, air travel will remain cyclical and vulnerable to regulatory and structural change.

I expect to see better opportunities to buy airline shares over the next couple of years. For now, I’m staying well away.


Diploma

  • Stock data should display here.
Market cap £3.4bn
RNS Half-year report
Writer disclosure No position

This FTSE 250 company doesn’t seem to have been covered on Cube before, so I’ll start with a brief introduction.

Diploma is an engineering and life sciences group with three operating segments:

  • Controls – specialised wiring, connects and controls used in many industrial sectors.
  • Life sciences – 85% of revenue comes from healthcare devices and consumables used for lab testing and medical procedures.
  • Seals – gaskets, filters and other such items used in heavy machinery and industrial equipment

My first impression is of a quality business with some attractive characteristics, such as a high proportion of repeat purchases.

Today’s half-year results are certainly positive and include a “significant upgrade to full year guidance”. I’ve included HY19 figures in the comparisons below so we can see how things looked before the pandemic. These numbers cover the six months to 31 March:

  • Revenue up 29% to £365.2m (HY20: £283.6m, HY19: £260.4m)
  • Underlying revenue growth up 2% (HY20: 1%, HY19: 6%)
  • Adjusted operating profit up 33% to £66.6m (HY20: £49.9m, HY19: £45.6m)
  • Adjusted operating margin up 0.6% to 18.2% (HY20: 17.6%, HY19: 17.5%)
  • Free cash flow up 57% to £34.3m (HY20: £21.8m, HY19: £14.0m)
  • Basic earnings per share down 7% to 25.5p (HY20: 27.4p, HY19: 26.4p)

What can we learn from this? It looks like underlying growth was pretty pedestrian, with underlying revenue up by just 2%.

The main source of growth appears to be last year’s acquisition of Windy City Wire for £357m. This is reflected in profits at the control division, which rose from £15.8m to £28.6m.

DPLM HY21 control segment

The Windy City acquisition was funded in part with a placing which raised £190m at a cost of 10% dilution. I’d guess this explains the fall in basic (statutory) earnings per share.

Adjusted profits: There are some hefty adjustments in the company’s headline figures. My sums show that the group’s statutory operating profit rose by 10% to £46.6m during the half year, giving an operating margin of 12.7%.

The difference between statutory and adjusted operating profit relates primarily to acquisitions:

DPLM HY21 profit adjustments

The “Acquisition related charges” entry of £20.3m for HY21 has two elements:

  • Amortisation of acquisition intangible assets: £15.8m
  • Acquisition expenses: £4.5m

I don’t agree with these adjustments. Here’s why.

Acquisition expenses: Diploma appears to be fairly acquisitive, making regular bolt-on deals. In my view, this means that acquisition expenses should be treated as ordinary operating expenses. Why ignore this (cash) cost of business?

Amortisation of acquisition intangibles: This reflects the amortisation (or depreciation) charge on intangible assets such as customer contracts, brands and patents.

Some investors are happy to ignore these non-cash accounting entries as they don’t affect cash generation. That’s true. But these amortisation charges do represent past capital expenditure by management on acquisitions.

As I mentioned above, Diploma’s management saw fit to dilute shareholders by 10% last year in order to help fund an acquisition. As a result of this deal, the group’s balance sheet now shows £564m of goodwill and acquired intangible assets. This total is now greater than shareholder equity, which was £496m at the end of March.

Capital allocation decisions such as acquisitions affect the future return on capital employed of a business. Ultimately, they drive long-term shareholder returns.

For this reason, I don’t agree with ignoring the amortisation charge on acquired intangibles assets. In my view, doing this overstates the true profitability of a business.

My view

I’ve added Diploma to my watch list, as it’s a business I could see myself owning at a more modest valuation.

Despite my comments on adjusted earnings above, the company’s historic free cash flow generation does appear to be quite strong.

However, I’d need to do more research to split out organic growth from acquisitions. I’d also like to understand the company’s cash generation a little better.

At current levels, Diploma is trading at around 35 times forecast earnings, with a dividend yield of just 1.2%. That’s too rich for me, so for now I’ll maintain a watching brief.


That’s all for today — apologies for running slightly late on the finish. Thanks for reading, I hope you found some of it interesting.

Roland

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