Icelandair: global investor November 2004

In October Icelandair surprisingly bought a 10% stake in easyJet as a pure investment play — the latest move in the interesting development of the Icelandic aviation business.

Icelandair is the main subsidiary of parent company Flugleidir, owned by the country’s leading banks and institutional and private investors, which describes itself as an investment company focused on the travel business. As well as Icelandair, which accounts for about 53% of turnover and 61% of net profits, there are 11 other units in the company, covering charter operations,regional operations, wet leasing, airport handling and Flugleidir Investments, which was established this October.

Flugleidir defines its corporate objectives explicitly in terms of shareholder returns: its target total shareholder return (TSR) is 19.5% per annum for the next five years, measured in dividends paid and increases in share value. It has, in fact, achieved an average TSR of just over 20% per annum over the past five years, although of course with significant annual variations.

Dividend policy is again stated clearly:

Flugleidir will pay out 30–40% of its net profit to shareholders over each business cycle (7–10 years). Its share price performance (listed on the Icelandic Stock Exchange) has been astounding by airline standards, or indeed any other standard — from a recent low of ISK1.75 in 2002, the price had soared to ISK9.8 by late October 2004.

The current stock–market valuation is ISK20.9bn ($303m), implying an historic p/e ratio of about 20, on a par with the most successful LCCs. This November Flugleidir’s board plans to raise its capital stock by an additional 230m shares priced at ISK8.8–10.2.

This year’s results will show a significant improvement on 2003 when net profit totalled ISK1.12bn ($16m) — pre–tax profit is estimated to be up by ISK1bn in the first nine months.

But the stock–market ratings also imply expectations of further aggressive expansion.

Flugleidir’s philosophy

In some ways Flugleidir sounds as if has been designed by management consultants, albeit with successful results. As well as reporting financials in standard accounting format, internally Flugleidir uses the concept of Economic Value Added (EVA, a registered trademark of the consultancy, Stern Stewart).

EVA is defined as the sum returned to the company’s operations after deducting a fee for the capital invested (including capitalised operating leases). The company uses a 9.3% capital charge, representing the weighted average cost of its debt and equity.

EVA is intended to focus the management’s attention on the balance sheet, with each unit concentrating on so–called EVA drivers, designed to maximise EVA performance.

More pragmatically, management bonuses are tied to EVA results.

With a tiny domestic market (Iceland’s population is under 300,000), the core airline business is not a growth area — rather expansion is envisaged through wet–leasing and investment activity.

Icelandair carried 1.1m passengers in 2003, a total that has been declining for five years. Operating seven 757s, Icelandair has two basic operations — a transatlantic hub at Reykjavik linking mostly Scandinavian and German points to six US cities, accounting for 36% of the traffic, and local Europe and US to Iceland traffic accounting for 64%. In recent years the hubbing traffic has been declining while the local traffic has been growing slowly.

Loftleidir, the charter and wet leasing arm, was loss–making in 2003 but increased its fleet from four 757s to five 757s and two 767s.

Loftleidir is allied to AWAS in a venture that markets 757/767s globally. This brings Loftleidir into competition with another Reykjavik–based wet lessor, Air Atlanta, which owns, including its UK subsidiary, 34 747, 757 and 767 cargo and passenger aircraft. Air Atlanta has just taken over domestic carrier Islandsflug, which itself is involved in the wet leasing business with a total fleet of 19 aircraft.

It has also just increased its stake in the UK charter airline, Excel Airways, which operates ten 737–800s and two 767s, to 71%.

Icelandair and Air Atlanta will also be competing for investment opportunities. easyJet looks to have been a good move — the share price before Icelandair entered the market was £1.32; by early November it stood at £1.70 and ABN–Amro has now raised the target price from £1.40 to £1.95.