IAG: Superior returns but
unappreciated March 2019

Annual results for 2018 from IAG showed another excellent year. Each of its operating airline improved in key performance indicators. At the Group level it exceeded its long term targets for margins and returns on invested capital. It achieved investment grade rating from the credit agencies. And it has increased its final dividend payout for the year and announced a special dividend. But the share price is 25% below its peak in June 2018. Are the market’s perception of clouds on the horizon real?

For the full year 2018, IAG generated a 7% increase in revenues to €24.4bn, an underlying operating profit of €3.23bn up by 9.5% year-on-year, and reported net profits of €2.9bn up by 45%. This resulted from an increase in capacity of 6%, demand of 7% and a growth in unit revenues of 0.1%. Fuel costs were up by 14% overall, but on a like-for-like basis unit costs fell by 1.9% over the year. The group is proud to note that ex-fuel unit costs have fallen by 11% in total since the formation of the group in 2011, and it is targeting a further 5% reduction by 2023.

The best performer in the group’s portfolio of airlines in absolute terms was British Airways, with a near 6% growth in revenues (in Sterling) to £13bn and a 12% growth in operating profits to £1.95bn giving it a margin of 15% and a return on invested capital of 17.3%. Capacity only grew by 3.5% but it achieved a unit revenue increase of 3% while underlying ex-fuel unit costs fell by 2%.

Aer Lingus continued a strong performance. It also generated an operating profit margin of 15% while revenues increased by 9%, capacity by 10%, unit revenues fell but unit costs fell at a faster rate of 5% as it increased its exposure to longer haul flying. It managed to increase its RoIC to an astounding 27%.

The Spanish carriers also improved even if the absolute levels were naturally lower. Iberia increased capacity by 7% and demand by 9%. Unit revenues fell slightly, but unit costs ex-fuel fell faster (by 2%). Operating profits improved by €61m to €437m giving it an improved  margin of 8.4% and an RoIC of 13.2%.

Vueling, despite significant disruption from ATC constraints and delays, had a reasonable year. Capacity was up by 9% and demand grew by 10%. Total revenues were up by 12.7% but while costs grew by 13.5% year on year it achieved a modest improvement in operating profits to €200m and achieved a 13.3% return on invested capital.

The group announced a proposal to increase the final dividend to 16.5€¢ a share (making a total for the year of 31€¢) and to offer a special dividend of 35€¢ a share (at a cost of €700m). The management was keen to point out that it has provided shareholders with cash returns of €2.7bn since it resumed dividend payments in 2015, through a mixture of ordinary dividends, share buybacks and special dividends, and will pay out another €1bn in 2019.

In the chart we show Aviation Strategy’s approximation of the returns provided by the top five European airline groups since the beginning of 2015. Admittedly, we have taken an arbitrary date from which to measure the share price performance, and the whole sector has fallen some 30% from peak share price values in the middle of last year. But from this picture it appears that IAG management may be justified in assuming that it has been able to provide superior returns to shareholders.

However, since the publication of the results the shares have continued to fall.

Coincident with the results the group announced it had firmed an order for 18 777-9X aircraft (plus 24 options) for delivery to British Airways between 2022 and 2025 to replace its remaining 747s and some of the older 777-200s. This should have come as no surprise: BA has a fairly chunky fleet renewal programme and the order was flagged as possible in the company’s capital market’s day presentations last November (see Aviation Strategy, "IAG: Creating value", November 2018).

There was also some confusion on the results call: the company guided that it expected operating profits for 2019 to be broadly in line with the results for 2018 but that capex would increase. It had to send out an emergency email to analysts to correct statements management made suggesting free cash flow would improve. Intriguingly Lufthansa underwent a similar confusion over free cash flow on its results conference — is this all to do with professional confusion over the introduction of IFRS16? (See Aviation Strategy, "No accounting for leases", April 2016.)

Brexit B******s

The reason for underperformance may have something to do with stock-market fundamentals. In late February IAG announced that it was restricting voting access to non-EU shareholders (always a part of its constitution) to the current 47.5% (note that Qatar Airways has a 20% stake). In light of this announcement MSCI stated it would remove IAG from its global indices, and as a result global tracker funds using them would be discouraged from investment in one of the top five global airline groups.

Secondly, while IAG publicly maintains a sanguine approach to the Brexit process, a large portion of its shareholder base is in the UK. Were Britain to leave the EU, these shareholders would no longer be qualified investors to be owners of an EU airline. And the question is the interpretation of the ownership and control regulation of an airline.

When the group was established in 2011, it put in place trusts for Iberia and British Airways so that it could prove to bilateral partners that ultimate equity ownership for those carriers lay in nationals of the designating country, in the unlikely event that bilateral partners would take the option to oppose access.

However, the European Commission has incorporated European ownership and control into law as a legal requirement for the operation of air services within the EU and EEA. Not that Brussels necessarily understands what this really means (Wizz Air is ultimately owned and controlled by US-based Indigo Partners, but not necessarily directly through issued equity; Qatar holds only 49% of the equity in Air Italy, but sure as dammit has control).

This antediluvian approach is stupid. The UK in its recent strategy white paper suggested that it would move to the ICAO model (proposed 17 years ago, and only adopted by a handful of countries) to designate any airline for international services that had its principal place of business in the UK.

This is a typically pragmatic British solution. IAG’s risk is that blinkered adherence to rules from Brussels could destroy the viability of a successful and profitable airline group.