Questor share tip: Sell Ryanair as profit guidance nosedives On the face of it, Ryanair shares are now much cheaper than they were three months ago, having fallen almost 25pc from highs at €7.48 in early August. However, the company may only be experiencing the early stages of an earnings decline as it faces the insidious impact of operational leverage on profitability, in which case the shares could have much further to fall. Running a fleet of aircraft, filling them with fuel, and staffing them, results in a high level of fixed costs. In practice, it roughly costs the same to fly an empty plane as it does to fly a full plane. The only difference is how many people you have on board and what price they are paying, and this affects the profitability per flight. This is a highly simplified example of operational leverage. After the 2008 recession, passenger demand fell sharply because costs are fixed; profits also fell very sharply to a pre-tax loss of €181m in 2009. Ryanair cut costs to the bone to improve profits so when passenger demand returned the sales increased rapidly. The effect of operational leverage was to boost pre-tax profits to €421m in 2011 and €651m in the full-year to March 2013. Ryanair is now facing sales that are slowing rapidly. The budget airline said it flew 1.2m more passengers, up to 49.2m in the first half ended September. However, fares have been lowered to entice passengers; average fares per passenger fell from €52.6 to €51.7 during the first six months. That represents an average fare per passenger decline of 1.7pc across the first half. Ryanair have now guided that average fares could fall 9pc in the third quarter, and 11pc in the fourth quarter. Investors may be confused as to why the shares moved so sharply when first half post-tax profits hit a record €602m in the first six months. The shares fell because first-half revenue growth at 5pc was less than half the 13pc growth rate in the full year ended March 2013. The effect of the slowing revenue on profit forecasts has been amplified by the operational leverage. Ryanair said that it expected full-year profits to be in the range of €570m-600m as recently as September; now the company thinks profits will be in the range of €500m-€520m. The size of the profit warning surprised city analysts. Investors thinking of buying the shares should take caution as the earnings could continue to fall. Ryanair is facing a competitive market for low-cost airline passengers and aggressive fare promotions to defend their share of the market are hurting margins. This all means that the shares may look cheap trading on 12.4 times forecast earnings, falling to 10.4 times next year, but the earnings figure has now become something of a moving feast. Taking a simple three-year trailing earnings figure of 32c per share - which seems prudent given the sales slowdown - would put shares on 16.6 times earnings, and that begins to look expensive for a company which pays no dividend and whose earnings look under threat.