European airlines: Why Ryanair is poised to take off

As consumers continue to spend on travel and experiences, many investors are looking for the best way to capitalize on this trend and optimize their portfolios.

Abhay Deshpande, Centerstone Investors Founder & CIO, joins Yahoo Finance for the latest edition of Good Buy or Goodbye, taking a look at European airlines.

Deshpande claims his Good Buy to be Ryanair (RYAAY) citing its low-cost position and low prices, which can draw in more customers. He also likes how it has a good balance sheet by keeping its fleet and costs narrowly focused and has a high-quality management team that can properly oversee the entire business.

Deshpande claims his Goodbye is Lufthansa (LHA.DE), citing its profits are susceptible to economic cycles, especially among economic headwinds, considering it is a higher-priced airline. Deshpande also says the airline is losing market share to low-cost providers, like Ryanair, and it has more leverage on its balance sheet and is therefore more exposed to higher interest rates.

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Editor's note: This article was written by Nicholas Jacobino

Video Transcript

JULIE HYMAN: It's a big, noisy universe of stocks out there. Welcome to Good Buy or Goodbye, our goal to help cut through that noise to navigate the best moves for your portfolio. And today, we're taking a look at European airline stocks as consumers continue to spend on travel, which stock is worth keeping grounded and which can take your portfolio to new heights? I'm here with Abhay Deshpande, Centerstone Investors founder and chief investment officer. Thanks so much for being here.

ABHAY DESHPANDE: Great to be here. Thanks.

JULIE HYMAN: So let's start with the big Irish airline, Ryanair, which also trades here in the US. It's done pretty well over the last year. In particular, over the last several months. But let's talk about your case here for why it's going to be a winner. It's a low cost airline, first of all.

ABHAY DESHPANDE: It's a low cost airline. And so in a commodity business, like airlines, like any commodity business, it's all about cost. It's about cost being the lowest in the industry and that tends to be the winner that you can apply that to pretty much any commodity industry. That is the entire basis of their operating model, down to the fact that they only operate the 737 airplane. So they don't have, like most other airliners, a suite of airline-- airframes. They have one airframe.

With that focus on cost, what they've been able to do is provide the lowest price to the consumer. It's also allowed them to narrow down in a world where-- in an industry where many things are out of your control, they've narrowed it down to a couple. Fuel and demand. So demand can go up and down, as you know, with the recession. But having the low cost operator down there, when demand falls, they tend to be able to actually gain market share because they can price at a level much lower than anybody else. What demand is there, they gain that market share.

JULIE HYMAN: All of this means that they also have a strong balance sheet because of some of the operating levers that you talked about, including keeping their fleet pretty narrowly focused.

ABHAY DESHPANDE: Yeah, I mean, that's-- if you're-- I'm not pitching all airlines. That's a terrible industry. If you're-- from my perspective, if you're going to invest in airlines, it's best to treat it like a commodity business, which means pick the lowest priced player. Also, focus on balance sheets because you do have-- I mean, during COVID, demand went to essentially zero. You need to be able to withstand kind of extreme environments. That also happened post COVID-- or post global financial crisis. So balance sheet is the second most important thing. Cost structure, number one. Number two is balance sheet. Number three is management, which we may get to.

JULIE HYMAN: Yes.

ABHAY DESHPANDE: But the balance sheet is extremely important. Here, where they've excelled, is they have not gone into fancy financial engineering in order to build the business. It's organic growth. They generate cash flow, they buy an airplane. They generate cash flow from that airplane, they buy another airplane.

JULIE HYMAN: So it's only airplanes that they can afford, effectively.

ABHAY DESHPANDE: Yeah, it's organic growth. So they're not borrowing a lot of money. They're not going to lease-- into the lease model. They own most, if not-- the vast majority of the airplanes, they may lease 5% or something like that. But that's a very different financial model than most other airlines. Including, by the way, Lufthansa, is also an owner, not so much a lesser.

JULIE HYMAN: All right, but don't jump us. We're going to get to that in a minute. So let's talk about the high quality management team as well, which you alluded to.

ABHAY DESHPANDE: Probably the most important thing a management team can do outside of managing the business, is managing the capital of the business.

JULIE HYMAN: Now we also like to point out potential risks, even for a good buy, right? And in this case, you've kind of alluded to it a couple of times, which is that airlines are not usually a great business, right? They tend to expand capacity by too much, for example. Or, you know, they buy too many planes, whatever it may be. So I guess there's always a risk that Ryanair could do something similar.

ABHAY DESHPANDE: Yeah, they could easily expand beyond their capability to maintain the financial model together, right? They could-- I think, since they've got most of it under control, a lot of the what could go wrong sort of scenarios tend to be things that they cannot control. You mentioned the economy, for instance. Regulation, what is happening in Europe next year? We don't even know.

What's happening next month, you know? So the kind of-- and they've grown substantially by adding services to the periphery of Europe-- Central and Eastern Europe. And if that becomes a war zone in the next couple of years, who knows? I'm not predicting that, but those types of things, obviously, have a much more-- much more of an impact on Ryanair. They're not a global player, they're really a regional player. So what happens in the region is extremely important.

JULIE HYMAN: So they're exposed to that region. Yes, most definitely. And you do own shares of Ryanair in your portfolio? Is that correct?

ABHAY DESHPANDE: We do, yeah. Yeah.

JULIE HYMAN: OK. Let's get then to-- quickly, to your goodbye. The one you don't like. You hinted at it. It's Lufthansa, the German airline. Those shares have gone down over the past year. So let's get you it here. First of all, here to susceptibility to the economic cycle, but this is not a low cost airline.

ABHAY DESHPANDE: So this is not a low cost airline, although they have a low cost segment. And this is-- and I pick these two companies on purpose. They're the only two companies I would buy because they're the only two of note, other than some Asian airlines, that actually own the fleet. Lufthansa does as well. There's a few differences. Lufthansa is built-- originally was built as a long haul carrier, meaning longer-- you know, international routes.

And they had some economic and sort of scale advantages with that model. Time has gone by, obviously, and more and more of the air traffic is intra Europe. And so that's where the low cost model has really taken a shine. I mean, you mentioned earlier, I mean, some of these tickets are like $25-- or, 25 euros one way, right?

JULIE HYMAN: And meantime, they're losing market share to the likes of Ryanair.

ABHAY DESHPANDE: They're losing market share to the likes of Ryanair. And the likes of Ryanair is-- Ryanair and Wizz Air are the main sort of the low cost competitors. They're losing some market share there and the valuations of the two businesses kind of also make me want to favor one or the other, right? This one is trading for six times operating profit. Ryanair is about eight times operating profit. But there should be a much, much wider gap and Ryanair is a trading and airline multiples, but it's a more or less a franchise.

JULIE HYMAN: Another contrast with Ryanair, the balance sheet here. It's got a more leveraged balance sheet. And therefore, has exposure to higher interest rates.

ABHAY DESHPANDE: Yeah. You know, mid-single billion, net debt. Now they've gotten into trouble. They've had to encumber a lot of their fleet that they owned to secure some financing during COVID. They're exiting that. They've spun off some subsidiaries, like a catering business. So they're finding ways to generate some cash. Or, to free up the balance sheet. It's not like a clear and present danger. They do have assets that offset the debt that's on the balance sheet. So that's-- it's not something that's going to impair the business or threaten their survival.

JULIE HYMAN: Right.

ABHAY DESHPANDE: But as an equity owner, in a total enterprise value situation, I'm more concerned about how much value is being detracted by the debt.

JULIE HYMAN: Right.

ABHAY DESHPANDE: Right, now we're talking about businesses that with a large amount of debt. It's--

JULIE HYMAN: It's not as attractive.

ABHAY DESHPANDE: Not as much left over for equity.

JULIE HYMAN: Yeah. And then we also like to talk about what could go right here. And this is a company that is at least supported by the German government. And so, that could help them out, but would that help the stock appreciate necessarily?

ABHAY DESHPANDE: So the number one thing that I think could go right is-- and this is not-- I don't think even a revelation, right? But they've now shown-- I mean, granted the gun pointed at their head, but they have shown the ability to create or try to unlock value for shareholders.

So a business that is, essentially, a government-- it's not government owned, but highly government influenced with the government put, basically, there's always a question mark who is-- for whom is this business being run? Shareholders or the government, or the local municipality? And in this case, you can see some shareholder friendly moves that maybe mark the change in mindset.

JULIE HYMAN: But maybe too early yet to get in on-- related to that.

ABHAY DESHPANDE: I wouldn't want to bet on that.

JULIE HYMAN: Yeah, yeah.

ABHAY DESHPANDE: You know?

JULIE HYMAN: OK. Well, interesting here because it's especially stocks we don't frequently talk about. So Abhay, thank you so much. You're telling investors, just to sum up here, to buy Ryanair for its low cost position, strong balance sheet, strong management team. On the other side, you say, avoid Lufthansa. It's susceptible to the economic cycle, it's losing market share to companies like Ryanair, and it's exposed to higher interest rates because of its balance sheet. Abhay Deshpande, thank you so much. Appreciate it. And that'll do it for the latest installment of Good Buy or Goodbye. Look out for new episodes three times a week at 3:30 PM Eastern.