Iberia - time for management to deliver March 2002

It has been an interesting 12 months for Iberia and its management. Iberia’s IPO in April last year just about succeeded, but this was quickly followed by another damaging confrontation with the pilots' union — and then came September 11. Despite all this, has Iberia has finally turned the corner in its struggle to become one of the long–term survivors among European airlines?

Through the early to mid–1990s the heavily subsidised and sluggish Iberia struggled to stay afloat, and it was only towards the end of the decade that it started cutting costs and adopting any kind of coherent long–term strategy (see Aviation Strategy, April 1998).

But those measures were enough to encourage Spanish state holding company Sociedad Estatal de Participaciones (SEPI) to start offloading its stake in Iberia, initially to "industrial partners" — British Airways and American Airlines — and then to institutional investors, thus giving its management a freer rein to run the airline on a properly commercial basis.

At last - the IPO

In April 2001, SEPI finally disposed of its remaining 53.9% in Iberia, although this being Iberia the IPO was anything but smooth. Merrill Lynch and Spanish bank BSCH handled the IPO, and the indicative price range given in March 2001 was €1.71- 2.14 per share, valuing the company at €1.6- 2 bn. This was well down on the price paid by British Airways and others during Iberia’s restructuring in March 2000, which implied a value of €2.7 bn.

Even at the lowered price, however, the airline’s roadshow to European institutions was not particularly well received. At the time the plan was to sell 49.9% of the shares on offer to private investors, which was a high proportion anyway. But it soon became clear that institutional demand was weak, so the retail share was increased even further. In the end, of SEPI’s 53.9% stake, 61.8% went to retail investors, 17% to Spanish institutions, 15.6% to non–Spanish institutions, and 5.6% to employees.

The issue was only successful after the share price was finally fixed at €1.19, well over a whole Euro down on the top end of the price range announced just a couple of weeks previously. There was probably an element of mis–pricing here, but many other factors had an effect, including general unease about the world economic climate, a difficulty in making non–Spanish investors understand the strategic benefits of Iberia’s access to Latin American markets, and concern about management’s continuing uneasy relationship with its unions. Nevertheless, SEPI was fortunate to get its stake away before the obviously unforeseeable events of September 11.

BA, American and other bank investors were able to invoke previously–negotiated clauses, giving them compensation on the difference between the value of the shares at IPO and the price they paid a year previously.

Yet before Angel Mullor, Iberia’s newly–appointed CEO, and chairman Xabier de Irala could fully focus on planning for the future, two devastating blows hit the airline — one foreseeable and one not.

Pilot anger …

Ongoing talks with the Spanish pilots' union SEPLA over pay and conditions had already led to a work to rule early in 2001, but a truce was called prior to the IPO process. Once the IPO was completed, however, matters rapidly escalated.

The details of the dispute were complex — and exacerbated by historically bad relations between unions and management — but the union’s basic position was that in the current pay and conditions round it wanted rewarding for Clause 104, the 1995 deal whereby employees agreed to a 15% salary cut in order to help Iberia escape from bankruptcy. Ground workers agreed to a new deal with Iberia in May 2001, but the pilots held out for better terms. Management refused to budge on its offer, which many saw as reasonable, and consequently SEPLA called 10 one–day strikes over the summer — which Iberia claimed would cost it Ptas 10bn ($51m) and force it to cut routes.

After the first three one–day strikes the government stepped in and imposed an arbitration process on the two sides, much to the annoyance of SEPLA. With both sides under enormous pressure to settle, a complex four–year deal was struck in July covering January 2001 to December 2004. Pilots received a 2.5% inflation–based raise for 2001, plus 0.5%, and pay will rise by inflation in 2002–04. Another 5% pay rise was agreed for 2003 and 2004, related to net profits in those years, and the Clause 104 problem was solved via a productivity–based rise over four years. A small "IPO bonus" of Ptas 1,013m ($5.3m) was also given to the pilots.

Management hopes that this deal will secure peaceful relations with unions over this period, solving what has always been one of Iberia’s key weaknesses.

… and September 11

But just as the future started to look bright for Iberia, September 11 hit. Initial management forecasts were grim — extra insurance costs alone would take €18m from the bottom line to the end of 2001, and overall passenger numbers dropped 8% in October compared with October 2000, with business traffic down 25%. Action needed to be taken, and in November 2001 Iberia announced it would cut 2,516 jobs from its airline workforce of 25,000 over 2002 and 2003, of which ground personnel would account for 1,857 and pilots 181. These will all occur through voluntary processes such as early retirement and voluntary redundancy, and will save Iberia an estimated €54m in 2002 and €108m in 2003. Encouragingly, management didn’t fudge this difficult issue, and indeed the unions agreed to the cuts in principle — perhaps the first real indication of a new understanding between the workforce and management. But the situation is helped by the fact that in Spain approved redundancy schemes mean that the government itself pays three years' worth of salaries and pensions of those made redundant, so the Spanish taxpayer bears the financial burden of most of these cuts.

In parallel, Iberia announced plans to cut 11% of its seat capacity, largely via reducing short–haul frequencies. This was done partly by termination of Iberia’s wet lease contracts for six 737–400s with Air Europa and two 747–400s with Air Atlanta, vindicating management’s earlier decision to keep marginal capacity in wet leases. Being Spain, Air Europa is suing Iberia over the "irregular" termination of its contract, although this action should be seen in the context of a bitter relationship between the two airlines following the collapse of merger talks early in 2001.

By the time of the fourth–quarter crisis Iberia had already retired its fleet of DC–9s and 727s, replaced by an extra 10 A320s and two A321s in 2001. Three A340s were also delivered in 2001, and another 17 A320s and A321s were scheduled to be delivered in 2002. In the wake of September 11 these were postponed, along with the planned issue of Iberbond IIs, which would have financed these acquisitions.

Last year Iberia was also due to announce replacement for its 747 fleet, used largely on its Spain–Latin America routes, but the choice between 777- 300s and A340–600s will now be made some time in 2002. Two A340s scheduled for delivery in 2002 have not been postponed, but until the replacement for the 747s is decided Iberia’s fleet renewal is not complete.

The current fleet stands at 143 aircraft (see chart, page 13), down from 153 in October 2001.

By the end of 2002 Iberia’s fleet will be around the 140 mark — considerably less than the 173 it was forecasting pre–September 11.

Traffic figures since October 2001 indicate Iberia is recovering relatively fast. Although RPKs fell 7.5% in October 2001 compared to a year earlier, there was steady improvement through the end of the year, and in January 2002 RPKs had risen by 1.9% compared with a year earlier. The recovery was largely due to the fact that North–American routes account for a much smaller proportion of Iberia’s passengers (and profits) than Latin American routes, which were much less affected by the September 11 fall–out. Overall, passengers carried in 2001 rose by 2% to 25m. This passenger recovery helped the airline to post a small €4.9m ($4.4m) operating profit for 2001, and a €50m ($45m) net profit in 2001 — both substantially down on 2000 but given the pilot strike and September 11 still a remarkable result.

(Pre–September 11, many analysts were expecting around a €70m net profit.) But this figure included substantial tax credits that Iberia had originally planned to include over several years, but which have now all been brought into financial year 2001.

No excuses in 2002

2002 will thus be a critical year for the airline, as the leaner, more efficient Iberia seeks to change from a focus on crisis firefighting to the positive pursuit of long–term strategy.

Key to this strategy will be Iberia’s large domestic market and its geographical position, making it the natural gateway to/from Latin America. The domestic market accounts for more than 60% of Iberia’s flights, and with a strong summer season forecast as Europeans return to Spain in large numbers, passenger numbers will be strong. In the Latin America–Europe market Iberia’s market share is estimated at approximately 15%, and these long–haul operations account for the majority of Iberia’s profitability.

Spanish business and leisure travel to Latin America continues to grow, while increased emigration from Latin America to Spain also benefits the airline.

Yet Iberia’s continues to suffer from poor service levels to passengers, both leisure and business. Although this is improving, it is not fast enough for the large numbers of travellers who prefer to fly any airline but Iberia when given a choice. The mass redundancies are hardly likely to help matters here, since inevitably the generous terms on offer (paid for by the government) are likely to encourage the most able members of staff to leave, while "less–flexible" people are able to stay if they want to.

Already 2,700 staff have applied for voluntary redundancy or early retirement, even though Iberia was looking for just 2,500 candidates.

A focus on higher productivity needs to be maintained (see chart, left), although the job reductions and cut in short–haul frequencies should improve the ASK per employee figure significantly in 2002.

Iberia’s sales and marketing effort continues to lag behind most of its rivals — for example, its confusing website is probably the worst among the main European carriers.

Feedback from some BA sources who have seen how Iberia operates on the ground is that the Spanish airline has a long way to go in adapting from a state–controlled environment to a fully–privatised mentality where the customer is king. These so–called soft issues may seem irrelevant compared with fleet or cost matters, but without a massive leap in professionalism Iberia cannot hope to compete long–term against other airlines.

All change in alliances?

Iberia appears to be prepared to reexamine its alliance strategy in the wake of BA and American’s seemingly losing struggle to strengthen their transatlantic alliance. “Iberia has to be part of one of the major alliances,'' said Enrique Dupuy, Iberia Financial Director. "Until now we have believed in oneworld ... and from now we have to see how far it serves Iberia’s interests and how far Iberia serves the interests of oneworld.''

The oneworld partners met at the end of February to discuss the future of the alliance, but no details of what was decided have been made public. The official line is that Iberia is not "excluding any possibilities", but is the new Iberia genuinely looking at all the alternatives to oneworld, or were its latest statements just designed to put pressure on the oneworld members (i.e.

American) ahead of the Ferbruary meeting? BA and American’s shareholding will not restrict Iberia’s strategic thinking, Iberia insists, and the airline has a variety of minialliances with non-oneworld airlines. The alternatives are clear: Lufthansa and United’s Star Alliance and Air France and Delta’s Sky Team, although Iberia sources hint Star might be more attractive for Iberia, particularly when looking at Star’s perceived need for more access to Latin America. Yet it could be easy to read too much into Iberia’s threat to leave oneworld — realistically, Iberia is going nowhere alliance–wise.

Only last December Iberia expanded its code–sharing with America to Washington D.C. and BA sources indicate they are keen to expand code–sharing on Europe–South America routes. And the reality is that BA and American hold a 10% share in Iberia, so if Iberia breaks away from oneworld these two airlines will have no strategic reason too hold a stake in the Spanish carrier.

Since BA and American should have no interest in being pure financial investors in other airlines (shareholders are free to diversify directly if they want to), this would mean a sale of their stakes sooner or later — with resulting further downward pressure on the Iberia share price — although an Iberia exit may be what BA and American want anyway, given their own troubles.

So can de Irala and Mullor really make Iberia a profitable European airline long term? For the moment, investors need convincing, and the share price, at the time around €1.50, is moving up and seems to be regarded much as the same as Air France’s.

Iberia has been briefing analysts to expect flattish revenue and modest profits in 2002, but expectations may be greater than that.

The excuses Iberia has always put forward for poor results in the past (union intransigence and the shadow of SEPI) have disappeared and it’s now time for management to deliver results to investors — investors who are likely to be much unforgiving of further poor performance than SEPI ever was.