City Insider: Lukewarm IAG will heat up as the optimists win out

City Insider: Lukewarm IAG will heat up as the optimists win out

Our City expert David Stevenson uses this month’s column to ponder why potential investors in the airline group don’t seem to be as keen as impressive recent financial performance would indicate

Why are BAs investors so lukewarm about the airline group?

Investors in IAG, the multinational outfit that owns BA amongst other airlines, should be in seventh heaven as a result of its recent full year numbers from the end of February.

Profits were up and efficiency measures near all time highs as the group finally delivered on its strategic plan.

Although boss Willie Walsh famously declared that he wanted to retire at 55 (he’s aged 54 currently) he’s clearly cruising for an even better set of results in the coming year, capping a career that has seen a major turnaround at the airline group.

Yet investors don’t seem to be cock a hoop.

Airline analysts certainly seem to be bubbling with enthusiasm for the group with most rating the stock a clear buy and some with price targets of as high as 800p or more – the shares are currently trading at around 564p.

But on the day of the results the shares actually slumped 4.8% after rising 5.28% the day prior in anticipation of higher profit.

And although the shares have more than doubled from lows of 226p back in 2011, they’re actually down over the last year (from 592p). At both the six month and 12 month level the shares are in fact down 6%.

This sceptical reaction from global investors  is despite record oil price lows and frankly superb  results. What's up and why are investors not racing to buy the shares?

Before I attempt to unpick this conundrum let's remind ourselves of just how good the results were from end February.

International Consolidated Airlines Group – its full formal title - reported a more than doubling in profit in 2015, an impressive result considering the hit on revenues after the fourth quarter impact of the Paris attacks.

Operating  profit was €2.3 billion ($2.5 billion) compared with guidance of €2.25 billion to €2.3 billion and pretax profit in 2015 grew to €1.82 billion from €828 million in 2014, as revenue rose by 13% to €22.86 billion from €20.17 billion.

Sales advanced 13% to €22.9 billion, though on a constant currency basis there was actually a small decline. The terror attacks in France wiped out around €45 million in sales.

Broken down at the divisional level, British Airways was the star of the show, again. It contributed the biggest profit for the group with a £1.38 billion ($1.93 billion) operating profit.

Iberia's operating profit also quadrupled, from an admittedly low base, while new acquisition Aer Lingus boasted an  operating profit of €124 million, of which €35 million is included in IAG results.

Dig a little deeper into the numbers and some impressive key metrics stand out.

In particular analysts at CAPA observed that the airlines group recorded its highest ever operating margin and blew past its return on capital objectives.

Return on capital employed is now running at 12.7%, more than 2.7% above its cost of capital.

This means that the airline group actually makes a profit on deploying its capital, a rare feat in the airline industry.

The Operating margin hit 10.2% although that increased to 11.9% for BA (the British airline now accounts for 82% of operating profits).

These strong financial metrics, coupled will sensible levels of debt, mean that IAG can actually afford to pay a dividend to its shareholders, another unique feature for a so called legacy airline.

Not all the numbers were quite so positive.

Costs rose by 9.3% with labour costs in particular up 13.4%. Those numbers are despite an estimated €400 million saving on the fuel bill.

Management clearly still have a struggle keeping the lid on labour costs especially at Aer Lingus.

But IAG also has a fearsome reputation for pushing down its cost base relentlessly and most analysts expect the group to comfortably hit its target for €3 billion operating profits in the current year, with €3.3 billion a distinct opportunity.

One tailwind might be IAG's fuel bill which should be around €1.2 billion lower in 2016 than last year.

At the current share price of around 560p IAG looks a bargain. The price to earnings multiple is 11.5, dropping to as low as 6 next year if we are believe some analysts optimistic assessments.

The yield is a healthy 2.6% which could rise to 4% if those analysts are to be believed. Debts are a bit high if we include the aircraft leases but interest cover is an exceedingly generous 6.8 times, so no hint of financial distress.

Overall I’d suggest that IAGs shares should be at least another 40% higher, which I would contend hints at broader investor concerns, some of them more macro economic, others specific to the business.

On the broad concerns, investors are clearly rattled by the possibility of a Brexit, even if the management don’t seem too concerned.

Anyone who says a Brexit will have no impact on markets need only look at this airline’s share price to realise that this optimism is entirely misplaced.

Another key worry is that investors are increasingly spooked about a slow down in global growth, especially in global trade which could badly hit BAs numbers (especially in business class).

There’s also a broader worry about capacity with the airline industry, a concern often articulated in this column. There’s potentially too much capacity coming online in the coming year.

Recent forecasts from OAG suggested overall 8% airline seat growth in Europe (against 6% last year). 

According to OAG , the group has about 10% of total seat capacity  and is expecting 9% growth, although  most of that is coming from Vueling.

Investors are increasingly worried that airlines will in effect order too many big shiny new aircraft just as the savings from dramatically lower oil prices should be kicking into profits.

To be fair  IAG has been cautious about ordering too many of the new 777-300 line, and negotiations seem to be continuing.

IAG can also persuasively argue that because it boasts high return on capital employed, it's actually makes sense to boost capacity, but I’m not entirely sure every investor signs up to this positive narrative.

I’d also observe that IAGs recent announcement that it intends to fly into Stanstead, Ryanair’s stronghold, might unsettle some nervous types who think that the airline is about to pick unnecessary fights with its lowcost competitors.

I would also add some group specific qualms.

There's a sense that Walsh may bow out in the next year or so after hitting record profits in 2016 and maybe even 2017.

This change in leadership introduces obvious uncertainty just as some investors begin to wonder out loud about the logic behind the international portfolio of trading businesses.

Iberia is steadily making a recovery but it's recent travails have meant that investors have tended to downplay the stunning turnaround at BA.

Then there’s all the talk about new tie ups, with the Qatar Airlines deal possibly hinting at the next big bit of M&A.

Add in the much delayed benefits of cooperation coming out of the LatAm Airlines deal (involving key outfits in Brazil and Chile) and you have the makings of an airline aggressively trying to build a big, diversified group of global airlines and alliances.

Does this massive diversification really make sense? Shouldn’t the airline just consolidate its existing conglomerate structure and not worry too much about new deals in the mould of the recent Aer Lingus deal?

Personally I think these concerns miss the whole point of the business.

IAG is meant to be a pure global diversified play on airlines, but there is a sense that hubris might be creeping into the airline’s management just as the cycle looks to be topping out.

On balance though I think the bulls and optimists will win out.

I think there’s a fair probability that we are not heading into a recession quite yet and if that is the case IAG could soar even higher.

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