In association with Travelport
David Stevenson takes a close look at all the business units that make up IAG and concludes that it is ahead of many of its rivals in terms of cutting costs and operating more profitably
A few weeks back over a family lunch I was literally left speechless by a friend who used to work at BA.
Now it has to be said that I’m rarely ever lost for words but our family friend had the good luck to have worked at BA for much of the last 40 years.
Now retired, over beer and chips he regaled us with his financial position (he’s not a pilot by the way – that would probably have made me have a heart attack).
To say he has benefited from an astonishing deal in terms of pensions, free travel and redundancy is I suspect an understatement of epic proportions.
He had quite literally been one of the luckiest people alive in the UK.
But even he admitted that the old model was bust and that he dreaded to think what it must be like to work for what is now International Consolidated Airlines or IAG for short.
The good news is that in fact IAG does seem to be thriving – with even better numbers on the way.
It’s difficult for any investor to get a proper picture so early in the year – the first quarter for instance is usually fairly weak for European airlines (and not helped this year by the timing of Easter ) – but by the middle of the year I think we’ll begin to see the outlines of a truly remarkable turnaround in the fortunes of our national flag carrier.
Just a matter of 24 months ago, matter seemed very different. At one point the 2011 all-share merger with Iberia looked to be in dire straits, losing cash at the rate of over £1 million a day.
Iberia’s 44% share in the combined entity looked to be a poor deal as Spanish pilots accused the British airline of being a carpet bagger out to use Spanish money to plug BA’s pensions black hole.
Full year numbers for 2013 from the end of February paint a very picture, with IAG back in profit and integration and cost cutting on plan.
The group’s operating profit hit €770 million in line with analysts’ forecasts while the EBIT margin increased to 4.1%.
Crucially return on invested capital (RoIC) moved from a big fat negative number to 5.6% although the airline admits that its cost of capital is actually closer to 10% – that number is probably only possible if the magic number for profits hits €1.8 billion.
Other highlights included a manageable debt position – gross debt stands at €4 billion with net debt less cash at €1.48 billion (although once we include aircraft leases that rises to €5.7 billion).
Crucially the Spanish partner Iberia reduced its pre-exceptional operating loss from €351 million to €166 million.
One of the clear drivers for the turnaround in group profitability is that operating costs fell by 1.3% over the last year, with two key positive drivers – fuel costs (a third of the total cost bill) fell by 2.5% whilst labour costs (a quarter of the bill) decreased 5% even though the airline actually increased staff numbers.
The bottom line is that these vastly improved results were mainly driven by significantly lower costs at Iberia and a maiden profits contribution from Vueling – more on that later.
Other deeper structural positives include the continuing strength of IAG’s long-haul portfolio of routes and the introduction of BA’s first Boeing 787 Dreamliners and Airbus A380s.
The real test though of IAGs turnaround is that the airline group has now set its sights on opening new routes. Iberia, for instance, has recently announced new routes to Santo Domingo in the Dominican Republic and Montevideo in Uruguay.
These full year numbers aren’t the only good news emerging from the IAG turnaround story in 2014. Back at the beginning of April the group reported a 10% rise in group traffic for March – passenger kilometres hit 15.53 billion compared with 14.09 billion kilometers in the year earlier period.
Also in the middle of March IAG agreed a key productivity deal with its ground staff in Spain which mirrors a deal already signed with local pilots and cabin crew.
The deal covers more than half of Iberia’s workers and builds on a previous agreement that cut pay for ground staff by 7% to market levels with an additional 4% cut based on productivity.
With this deal in place Iberia should be able to generate enough profits to buy some brand shiny new airplanes. Crucially IAG announced that pay increases in the future will be linked to the airline’s productivity.
Given this spate of more than half decent recent numbers it’s no surprise that most city analysts reckon that the next two years should produce even bigger profits.
Most analysts I’ve talked to about IAG are enthusiastic – Irish firm Goodbody for instance has a strong buy on the stock as does Cantor Fitzgerlad Europe, although HSBC recently downgraded the airline to neutral from overweight, citing strong share price returns in 2013.
But even the world’s local bank said that it expects earnings momentum to continue into 2014 from restructuring at Iberia and a stronger economy although it also admits that it’s worried by the possibility of lower yields as industry capacity starts to grow again.
That positive outlook from analysts is shared by the airlines management, with 2014 numbers looking ‘stable’ – revenue is likely to be flat while costs continue to fall – although IAG did admit that its cargo business is struggling.
The group has set a target of €1.8 billion in group operating profits by the end of 2015, but Stephen Furlong, an aviation analyst at Davy, reckons the group could achieve closer to €2 billion.
The airline should benefit from a number of positive headwinds in 2014. The first big plus is that renewal of its fleet – according to a CAPA report its new A380 aircraft, offers a cost per seat advantage of around 18% versus the 747-400.
“The larger aircraft are configured with 469 seats compared with 317 on average for the 747” says CAPA, “but the total trip cost from London to Los Angeles is only 22% higher.”
IAG may also benefit from lower fuel bills. In 2014 the fuel bill will probably hit €6.1 billion versus €6.0 billion for 2013. But oil prices are likely to remain subdued – a 1% drop in fuel unit costs would deliver €1.4 billion and a 4% cut would get the group all the way to its 2015 target of €1.8 billion a year early.
If IAG does hit that 1.8 billion Euro number early, it’ll be kilometres ahead of its peer group – the Air France KLM combo, for instance, recently announced first quarter numbers showing a narrower loss. Its Transform 2015 restructuring seems to be on track but its freight business is clearly also in trouble and losses are increasing at the group’s LCC rival to Vueling, Transavia.
IAG has cracked the challenge of running of different products and brands under one corporate roof. Its low cost brands include Vueling and Iberia Express.
The latter business airline had been the subject of a bitter dispute with its Spanish pilots union but a recent Spanish supreme court decision has given the unit clearance to expand rapidly.
This business has non-fuel costs that are a staggering 40% less than Iberia’s and is already covering the cost of capital. Iberia is now ideally positioned to expand its short-haul offering to act as a hub feeder airline for the long-haul core business.
But my guess is that the business with stronger potential is Vueling, under chief executive Alex Cruz.
This airline has been rapidly expanding throughout Europe using a point-to-point model and contributed €168 million to the group’s operating result in 2013 – revenues were up 28%, capacity increased 22% .
Vueling’s own operating result for the full year 2013 was €137 million, with revenues up 28% on a capacity increase of 21.9% and profits are now running at four times those of 2012.
Add it all up and I suspect that IAG has a number of structural advantages over its peers. Those LCC businesses – Vueling and Iberia Express – give the ability to flex different business and product models as different national markets recover at different speeds.
Unlike many of its peers its growing portfolio of brands allows it real strategic flexibility to take on different competitors at the same time.
IAG is also fast approaching the point where it’s actually – miraculously – covering the cost of its capital. That’s an astonishing achievement for an airline, and given its flexibility to negotiate better financing deals and also puts it in a strong position with any future strategic partners.
IAG is also making phenomenal progress in its cost reduction programme – those costs are still too high to be sure but compare it to virtually every other peer operating out of key hub airports such as Heathrow and its numbers are hugely impressive.
One simple, bold statement sums up this achievement – according to chief executive Willie Walsh his business is on target to reduce unit costs in 2014 whereas Easyjet expects an increase.
Last but by no means least, IAG is now ideally positioned to ride a strong recovery in both the UK and Spain, which should in turn help push customers into its lucrative long haul portfolio. Add in more efficient planes and new routes and IAG could be onto a winner.
Obviously there are still huge challenges ahead not least that its legacy pension commitments are still a millstone around its neck – although the deficit has been reduced to well under €300 million.
It’s also clear that IAG has a few problems at Gatwick where its fighting off a fast expanding Easyjet with a bunch of old planes and older routes.
But my well endowed (in pension terms at least) friend has possibly the best analysis:
“They still have a bloody dominant position on what is still the best hub airport on the planet despite all the huffing and puffing about expansion. Every year those cost savings will keep flowing through to the bottom line especially as my generation vanishes from the payroll.”
All of which I suspect is good news for our friend – those improved profits should help pay for his 20 years in retirement.