TheChek News Flow

Cross Asset – Equity & Credit View On European Airlines – A Fast Start to 2016

While we reiterate our over-arching structurally bearish equity and credit view on the

European airlines, we have become more selective in our recommendations on the downside

for 2016, in a world where fuel continues to show signs of being lower for longer. Our

favoured Underperform/Underweight across both equity and credit remains Lufthansa, with

both the significantly levered (and less liquid) Norwegian Air Shuttle and the much-loved IAG

also maintaining their Underperform equity ratings. This does not represent a change in

stance. However, we do move our equity recommendation on easyJet to Neutral, now

alongside the pre-existing (equity) Neutral and (credit) OW on Ryanair. But the key call today

is that we upgrade AF-KLM to Buy/OW in equity/credit, respectively.

AF-KLM's shares spent the last four months underperforming close peer Lufthansa as

threats of strikes and terrorism have concerned investors. And while it is hard to argue

that AF-KLM is a secular winner with its relatively high average fares and inferior cost

base, there are three factors that catch our eye: 1. EBIT momentum: AF-KLM has the

lowest fuel hedging (54% in 2016) of the legacy carriers. And alongside a c.30% fuel price

drop in Q4’15, this could mean a total c.€1.5bn YoY fuel cost savings in 2016 for AF-KLM,

in the context of a company that has a likely out-of-date consensus EBIT of only c.€742mn

in 2016. While this saving will partly be passed on, via lower fares, we struggle to see how

‘all’ of it will be, given our analysis concludes AF-KLM is by far the most capacity

disciplined Euro-airline. In fact, AF-KLM’s recent yield growth has in our view actually been

better than Lufthansa and IAG. To that extent (largely via fuel), our equity forecasts expect

AF-KLM to beat consensus EBIT by c.+90% in 2016, 2. FCF yield: Recent capex cuts by AFKLM

will likely underpin FCF, allowing for a top quartile 2016 FCF yield of c.18% & 3.

Negative sentiment: In the last 25 years, the shares have fallen some c.90% (high to low),

short-interest has built to high-single-digit-% levels and Bloomberg suggests the sell-side

has 9 ‘sells,’ ‘13 holds’ & a mere 6 ‘buys.’ Without wanting to pour scorn on the negativity,

the shares are likely trading on 2x P/E in 2016 and close to a historical low EV/IC of 0.57x

with EBIT ramping; an attractive risk-reward for a leveraged behemoth.

easyJet shares have been dragged along on Ryanair's category-killing coat-tails in the last

18 months, underperforming its counterpart by c.50%, as the latter used its lower price point

and cost advantage to stage a European market share upheaval. In fact, over this period,

easyJet appears to have gone from premier-market-darling to somewhat of a (sizeable) me-2

operator in airline investors' minds (alongside Norwegian, Vueling and Wizz; all with parity

fares and products). The performance disparity between Ryanair and easyJet has become so

dramatic that easyJet’s bulls seem to have even stopped discussing traditionally-accepted

profitability metrics; e.g. fare growth (now falling at easyJet) and costs (rising at easyJet).

What is changing in 2016? We expect the newly minted CFO to deliver a credible cost plan at

the H1 results (necessary in a low yield backdrop). With such a potential catalyst on the

horizon, our Underperform lacks validation and we move to Neutral.