Interactive Investor

Stockwatch: betting on return to FTSE 100 for this mid-cap share

Following recent advice on this sector would have made a handsome profit. Now, analyst Edmond Jackson thinks a larger peer is in a good place and set to do very well over the next few years.

5th December 2023 11:38

Edmond Jackson from interactive investor

On 10 October and in response to renewed Hamas/Israel conflict, I opined it probably would be best to avoid airline stocks unless they became oversold, “although specialist travel stocks such as On The Beach Group (LSE:OTB) may enjoy selective appeal – for example as consumers look for better value in foreign holidays”.

On the Beach shares were trading at around 105p and slipped to 92p in late October but then rallied 28% through November and are currently 135p after strong annual results this morning. 

Meanwhile, easyJet (LSE:EZJ) fell from 440p on 10 October to 360p on 20 October then rallied over 30% to around 465p currently. Strong annual results to 30 September were published on 28 November, which further drove a rise from 405p. 

It is another example of the challenge to discern what might be specifically attractive in company fundamentals, amid many re-ratings during November due to a shift in expectations for interest rate cuts in 2024. That indeed would be rational for stocks exposed to consumer discretionary spending, but has the market got ahead of itself, and should you chase the momentum? 

Both these stocks remain at long-term lows on their charts, despite tweaking upwards. I am positive on them, would reiterate “buy” On The Beach and consider eating my words as regards easyJet. We have new information and, as John Maynard Keynes was reputed to have said: “When the facts change, I change my mind.” 

Recent research has shown that three-quarters of Britons plan to spend more on their holidays than last year, with travel remaining the top priority for discretionary spending. 

Robust performance and positive outlook for easyJet 

I would try to focus on key essentials and the medium-term context. 

Revenue has rebounded 42% at easyJet, with three years of losses becoming a £324 million net profit (see table). A positive outlook is declared for the September 2024 year, helped by booking strength for summer 2024 plus supply constraints in Europe.  

After high single-digit operating margins turned negative due to Covid, this performance measure recovered to 5.5% at the reported level (after depreciation costs) despite a 40% hike in fuel costs and other inflationary hits. Free cash flow is building, with capital expenditure taking less than half of operational cash flow.  

A return to dividends is thus being made, with a 4.5p per share final dividend, and if 15p is achieved in 2025 (as is consensus) then the prospective yield would be 3.2%. While nothing special, it would be covered over four times by earnings per share – using the consensus it rises to over 56p in 2024 and 65p in 2025. 

If such earning power is achievable, it represents a forward price/earnings (PE) ratio of just 7.2 times. Obviously, that is forecast-based and airline stocks tend to be rated modestly given inherent risks.  

easyJet - financial summary
Year end 30 Sep

 2017201820192020202120222023
Turnover (£ million)5,0475,8986,3853,0091,4585,7698,171
Operating margin (%)8.07.87.3-29.9-62.4-0.55.5
Operating profit (£m)404460466-899-910-27.0453
Net profit (£m)305358349-1,079-858-169324
EPS - reported (p)64.775.974.0-223-159-22.442.7
EPS - normalised (p)65.411073.4-148-174-13.447.2
Return on total capital (%)9.49.38.5-19.3-12.8-0.48.0
Operating cashflow/share (p)141204161-158-192103205
Capital expenditure/share (p)13421520914427.670.499.5
Free cashflow/share (p)7.0-11.0-48.0-302-22032.7105
Dividend/share (p)34.449.337.00.00.00.00.0
Cash (£m)1,3281,3731,5762,3163,5363,6402,925
Net debt (£m)-357-3963261,125910670-41.0
Net assets (£m)2,8023,2332,9851,8992,6392,5332,787
Net assets per share (p)594685633350348334368

Source: historic company REFS and company accounts

Yet easyJet is no longer a pure airline play, its holidays side is growing well – possibly or at some point, representing a quarter of group revenue (although the presentation is complicated. See note 1 to the accounts on accounting policies).  

Even if you take management’s medium-term goal for £1 billion pre-tax profit with a pinch of salt, that implies earnings per share (EPS) of around 107p and a PE of just 4.3 times.  

They reckon on this by achieving pre-tax profit of £7 to £10 per seat (some advance on roughly £3 this last year), also reducing winter losses, growing the holidays side to over £250 million annual profit, and cost savings from fleet efficiency.   

Despite some risk of consumer retrenchment in the early months of 2024 – if economic pressures finally capitulate to job lay-offs – I would think the January holiday sales spree is pretty secure. With easyJet in rude health, likely benefiting (as with On the Beach) from trading down from pricier operators, I am not inclined to bet against it. 

That is underlined by short-selling data showing stock-on-loan having declined from a peak of 8.9% in May 2020 to 1.2% this last month As of December it has unwound completely (probably in reaction to the results). 

Attractive chart context but mind dilutive factor 

It is easy to look at easyJet sitting near lows on its chart going back 20 years, and think surely the group’s capacity and service reach have advanced substantially since then? 

But there is now a material 758 million shares issued, especially after a September 2021 rights issue at 410p raised £1.2 billion. Shareholders were able to buy 31 new shares for every 47 held. 

Despite this material adjusting factor, the chart has appeared to put in a “double bottom” at 312p in October 2022 and 360p a year later, even if this is in truth much higher than a 250p low in the 2008 financial crisis and around 120p way back in May 2004.  

In between, it re-rated to over 1,000p in 2013, lasting volatile-sideways until Covid’s disruption in March 2020, with a February 2015 high at over 1,500p along the way. My recollection was easyJet trading on premium PE ratings during this time, which put me off, but mean-reversion (even adjusting for dilution) looks to have completed. 

I am not surprised, therefore, that the stock has responded sharply to strong results, and think we should view it in wider context than a 30% recent rise. If consumers prioritise travel like research suggests, its medium to long-term upside potential is attractive. 

Operating performance measures bode well  

The 42% revenue advance was achieved due to pricing strength, increased capacity flown, better load levels (of passengers and baggage), and also continued growth in holidays sold. It affirms an ability both to read and take advantage of firm consumer demand, despite interest rates rising over the financial year.  

Despite a 30% hike in headline costs to £7,716 million - again due to greater capacity flown, also fuel costs up 40% and general inflation - £432 million profit was achieved at the pre-tax level versus a £208 million annual loss previously. 

If you are willing to look beyond depreciation charges and focus on EBITDA (which management naturally likes to emphasise) margin is up from 10% to 14%. 

October showed “strong” year-on-year profit growth, and revenue on early bookings up to September “pleasingly ahead of last year.” The upward trend on the holidays side continues.  

Mind, early winter results “will see an impact” from the Middle East conflict, where flights to Israel and Jordan have been paused, and there was a broader impact on flight searches and bookings, hence the seasonal first-quarter loss is not expected to improve.  

At least, and in contrast with fears a month ago, conflict has been contained to Gaza – unlike predictions it would spread in the region.

Strong balance sheet with low financial risk 

Long-term debt (excluding leases) has been cut from £2,760 million to £1,462 million, alongside near-term debt stable at around £430 million. Admittedly, cash has also reduced, from, £3,514 million to £2,925 million, although that still means a net cash position of around £1 billion.

Mind that an extent of that may relate to customer account balances, pre-paid, not the group’s own cash. Then there are nearly £1 billion of leases, albeit still a netting off, and goodwill/intangibles are scant. Net interest charging is nearly eliminated.  

Barring a more serious Middle East war and/or recession gripping the UK and Europe, I target easyJet to double over three years or so. Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor. 

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