The FTSE 100 has surged 17% in the last year, but easyJet (LON:EZJ) has slumped 38%. For some investors, a large share price fall could dissuade them from buying. However, I’ve always been more interested in buying shares which have fallen in price. I think they often offer less risk, not more risk, and such situations have delivered some of my biggest profits from investing.
Undoubtedly, easyJet has declined by such a large margin for good reason. The European airline business is experiencing a difficult period, with terrorism hurting demand and lower fuel costs pushing the supply of seats higher. Uncertainty in Europe is also high because of Brexit, which could lead to a worse financial performance for the company.
However, in my view those problems are priced in. I think easyJet is a sound long-term buy and while its shares may be volatile over the short run, they could offer relatively high capital gains and an above-average income in the long term.
Low valuation
The FTSE 100 is within 200 points of its all-time high. Although on its own this is insufficient information to deduce whether it offers fair value, it does provide an indication of investor sentiment.
Investors are mostly bullish about the prospects for the index, which surprises me to a large extent because of the uncertainty present in the global economy. Namely the risks from Brexit, the policy action by President Trump and a slowing China.
Therefore, I’m finding it more difficult today than I did a year ago to find stocks which are truly, genuinely and unmistakeably cheap. Few companies now trade on single-digit P/Es, for example. That’s to be expected given the FTSE 100 has a CAPE of around 16.
But since easyJet’s P/E is 8.9, it immediately stands out to me as a stock which could be inefficiently priced, given the current mood of investors. It may come with risks, but the potential rewards from performance being better than (or at least not as bad as) expected could be relatively good.
Margin of safety
When easyJet’s financial performance and outlook is considered, it’s unsurprising the stock comes with a wide margin of safety. In FY2017 it is forecast to register a fall in EPS of 27%. This follows FY2016’s 22% drop in EPS, bringing the expected decline in EPS to 43% in just two years. Investors are probably expecting a similar performance in the next two years, given the company’s lowly valuation.
On the face of it, they might be right. easyJet faces a squeeze in demand and a flood of supply, both of which are hurting its financial performance. Low oil prices – which are generally a positive for airlines, as fuel bills make up a sizeable portion of their total costs – are sending capacity higher.
…since easyJet’s P/E is 8.9, it immediately stands out to me as a stock which could be inefficiently priced, given the current mood of investors.
easyJet has responded by raising its capacity, but a falling load factor means it is running hard just to stand still. At the same time, demand is sluggish as consumers are nervous following terrorist incidents in the last couple of years. There is no way of knowing if this will continue, but I feel the situation is unlikely to change in a matter of months.
Another area where easyJet is experiencing challenges is forex translation. Its most recent update stated it will record a forex loss of £105 million for the full year due to sterling’s weakness. The trend of a weaker pound will continue throughout 2017 in my opinion, since I think Brexit negotiations will not indicate a deal is likely.
The effect of this on investor, business and consumer confidence in the UK could be negative and push the pound’s value even lower. This may be compounded to some extent in easyJet’s case by the reduced spending power of UK consumers abroad. Overall, a weak pound could act as a short-term drag on the company’s share price.
Positive catalysts
Although the airline’s profitability has declined and is expected to do so again this year, in FY2018 easyJet is forecast to register a 13% rise in EPS. This could help to reverse declining market sentiment in the stock and lead to a higher valuation in my view.
Forecasting the company’s financial performance is clearly difficult given the uncertainties it faces on a macro and micro level, but a return to EPS growth is likely in my opinion next year as cost cutting strategies have an impact. For example, in its most recent quarter it delivered £14 million of lean cost savings.
Allied to this is a dividend yield of 4.1%, with dividends forecast to rise 15.3% in FY2018 to give a prospective yield of 4.7%. Even then, dividends are expected to work out at just 50% of earnings in FY2018, which indicates to me they will follow an upward trajectory even if profitability disappoints.
Given an inflation outlook which could see the price level rise by 4% or more in 2017/18, I feel a high dividend yield backed up by a fast-rising dividend could shore up investor sentiment in easyJet’s stock over the medium term.
Outlook
easyJet is not without problems and significant risks. A low oil price means capacity within the airline industry is likely to rise, which could suppress pricing and the company’s load factor. Simultaneously, demand is under pressure due to recent terrorist attacks.
Compounding all this is the potential impact of Brexit on the European and UK economies, which could cause further problems for the company’s profitability. Further, it could also be hurt by weak sterling, a trend which will continue this year in my view.
However, I believe the budget airline is a buy. It is dirt cheap at a time when the FTSE 100 is near an all-time high and given it is forecast to return to EPS growth in FY2018, I feel its valuation could rise significantly. The company’s cost cutting measures should also help to turn around its financial performance, while relatively appealing dividend prospects enhance the investment case yet further.
For investors who cannot live with volatility in the short run, easyJet may not be suitable. However, for those who can buy and ride out what may be a difficult period in return for potentially high rewards down the line, it seems like an appealing buy.