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IAG: The most vibrant November 2014 Download PDF

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Once again, the pronouncements at International Airlines Group's annual capital markets day at the beginning of November showed how the anglo-hispanic Group is outperforming its European peers. Unlike the other two major network carrier Groups in Europe, it had no need to dampen investor expectations, reinforced its target to achieve a €1.8bn operating profit and a return on capital in excess of 12% in 2015, and expected to be able to declare a sustainable dividend to shareholders next year.

IAG is benefiting from the relatively more vibrant British (and recovering Spanish) economies in contrast to the lacklustre performance in France and Germany. It also has seemingly successfully imposed its restructuring plans on Iberia, to the point where the Spanish carrier is expecting in 2014 to post its first operating profit for six years. As a late entrant in the game of consolidation mergers, its performance may also have as much to do with the Group structure (it could learn from errors in the mergers of Air France-KLM and the acquisitions by the Lufthansa Group). Also British Airways went through its major industrial reorganisation a decade ago, something that its peers are only now attempting.

Group targets

IAG Operating profits by airline brand
_perating_profits Produced by GNUPLOT 5.0 patchlevel 0 -1,000 -500 0 500 1,000 1,500 2,000 2007 2008 2009 2010 2011 2012 2013 2014 2015 EURm Operating profits BA IB VY IAG BA IB VY IAG Total

Source: company reports

During the presentations at the Capital Markets Day the management expressed optimism. It has raised its guidance for full year profitability in 2014, looking to an improvement in Group operating profit (before exceptional items) of between €550m and €600m to about €1.3bn. It also expressed confidence in its ability to meet (and presumably exceed) its 2015 operating profit target of €1.8bn. The improvements in results for 2015 are expected to come from: new fleet net savings; productivity improvements; completion of the Group's 2011-15 synergies programme; and profitable growth. It also stated that it could gain a further positive impact from the recent movements in the fuel price and foreign exchange rates.

The target €1.8bn operating target for 2015 would provide the Group with the approximate 10% margin and 12% RoIC that it needs to achieve a positive return against weighted average cost of capital (last achieved at the top of the last cycle in 2008). Beyond 2015 it is aiming to generate a return on invested capital of over 12% for the Group and each operating airline within the Group. It states that it will be able to do this through: productivity and other non-fuel related savings within the Group and through individual operating company initiatives; the net savings from renewing the fleet; and flexibility in growth. Importantly for the stockmarkets, the company gave clear direction that it will be able to declare a sustainable dividend (first for the Group, and first for BA since 2008).

At the Group's investor day this time last year IAG outlined that its strategic financial plan rested on four “planks”:

  • “Transform Spain” to bring Iberia back to profitability and a sustainable growth path;

  • “Transform London” to improve performance at BA through increased and retained unit revenue performance and margins;

  • Extracting further synergies from the combined Group; and

  • Growth potential at BA and Vueling.

Each of the first two planks were expected to generate improvements in operating profits of around €300-400m while continuing synergy benefits and growth at BA and Vueling would add €190m and €200m respectively. With the raised guidance for operating profits of €1.3bn in the current year, the Group is over half way to its 2015 target. While it has not at this stage done anything about raising expectations for next year, the management did point out that it had increased its estimates of total revenue synergies in 2015 (by €100m to a total €700m) and that its plan was based on a fuel price of $950/tonne (currently c$760/tonne).

Beyond 2015 the management clearly stated a desire to maintain a 12%+ RoIC and double digit operating margins in all the airline operating companies. For Iberia this means continuing its restructuring plan and accruing the labour cost and efficiency measures in place, while at the same time generating growth by restoring long-haul routes from which had withdrawn. For BA it aims to reap deeper benefits from the acquisition of bmi and its joint venture partnerships.

At the Group level it will be aiming to create additional synergies through its Avios common loyalty currency; a pooling of all cargo operations into a single brand, IAG Cargo, which it hopes will provide an engine for profitable growth in a troubled market; moving increasingly towards common purchasing; and a Group wide Business Services/IT platform.

Even including relatively high growth rates at Vueling, the Group appears to be planning only a 3-4% annual average increase in capacity between 2016 and 2020. The Group is assuming that yields remain flat over the period, while the fleet renewal programme (particularly at BA) is generating significant improvements in fuel efficiency. A large part of the anticipated earnings improvement up to 2020 seems to come from squeezing supplier costs


BA is gradually renewing its long-haul fleet. It now has eight A380s and eight 787s in service with another four and five respectively due to be delivered next year. These are being used to replace ageing 747s and 767s creating a modest increase in average long-haul gauge. In addition the A380 is freeing up slots at Heathrow as it allows for a reduction in frequency on the high density routes on which it is being used. At the same time BA is disposing of its 737 Classics (all should have left the fleet by the end of next year) as more A320s are delivered. Iberia meanwhile continues to take on new A330s on lease (as an interim measure until the A350 comes on stream) gradually replacing the older fuel-hungry A340s (although some of these are still required for the “hot-and-high” destinations in South America). The 133 aircraft on order for delivery between 2016 and 2022 are primarily to secure fleet replacement with modest growth; the additional 193 options over that period could generate long term growth of 5% per annum — but the Group has significant flexibility over the next decade on how much capacity to put into the system depending on market conditions.

IAG Fleet Plans
Post 2015
Aircraft 2012 2013 2014 2015 Orders Options
A330 / 340 33 29 31 32 8
A350 26 42
A380 3 8 10 2 7
747 52 49 43 39
767 14 12 7 4
777 52 54 58 58
787 4 8 13 29 18
A318 2 2 2 2
Total long haul 153 153 157 158 65 55
A320 family 187 227 266 287 68 178
Other 40 39 35 27 15
Total short haul 227 266 301 314 68 193
Total fleet 380 419 458 472 133 248
Source: Company presentations

One major potential long term synergistic benefit for the Group may come from fleet harmonisation across the airline operating companies. IAG's head of strategy Geoffrey Weston highlighted the opportunities they are pursuing to create a common aircraft specification for the fleet across the Group. The intention was to meet three main goals:

  • Lowest cost — purchase and operating;

  • Reduce capital intensity: lower long term maintenance costs and future modification costs while retaining the separate brand identities;

  • Greatest flexibility: generate the ability to shift aircraft between airline brands within a minimum time and expense.

As an example the Group currently has some 259 A320s within the three carriers located at 26 separate bases. Each operating company has its own specification on a multitude of items (and sometimes multiple specifications within a single operator's fleet) which include the design of the toilet doors, layout of the galleys, type of cabin flooring, cabin crew seat covers, position of emergency signs, design of taps, mirrors and other furniture in the toilets, and even the design specification of the cockpit windows, or the inclusion of a second jump seat in the cockpit. In all, there are some 400 choices across 250 categories for the specification of the cabin interior, avionics and systems and emergency equipment.

IAG Short haul fleet flexibility
Gnuplot Produced by GNUPLOT 4.6 patchlevel 3 60 70 80 90 100 110 120 130 2014 2015 2016 2017 2018 2019 2020 Index (2014=100) IAG Short haul fleet flexibility Gap closable by leasing, second-hand, delayed retirement, exercise options gnuplot_plot_1 gnuplot_plot_2 Planned (CAGR +3.5%) Minimum commitments ( CAGR -4%)

By harmonising the current fleet the Group is reducing the number of individual suppliers (and thereby increasing its buying power), reducing the weight of the aircraft by up to half a tonne (and generating up to €45,000 savings in reduced fuel-burn per aircraft per annum). The new specification will also cut the cost of each aircraft by €1m and have a longer-term positive impact on maintenance costs. The more important potential comes from the resulting ability to switch aircraft between brands easily and quickly (estimated to be around a week for switching between BA and the Spanish companies, or less than a week for a switch within Spain), divert new aircraft to a target operator more easily before delivery, and allows for maintenance in multiple sites.

IAG Long haul fleet flexibility
Gnuplot Produced by GNUPLOT 4.6 patchlevel 3 70 80 90 100 110 120 130 140 2014 2015 2016 2017 2018 2019 2020 Index (2014=100) IAG Long haul fleet flexibility gnuplot_plot_1 gnuplot_plot_2 gnuplot_plot_3 gnuplot_plot_4 Planned long haul aircraft (CAGR +3%) All options (CAGR +4.5%) Minimum commitments (CAGR +1.5%) Downside (CAGR -4%) Firm orders, accelerated 747 retirements

IAG is dumping the old BA and IB legacy thinking for specifying new aircraft types, and seemingly getting rid of the old ideas of sub-fleet optimisation. For example, Iberia has confirmed the order for eight A330-200s due for delivery from December 2015. For the first time (also involving British Airways in the process) it worked on a philosophy of designing the aircraft’s final specification starting from a zero base (maximum density and minimum weight) allowing brand differences only on a strong revenue case. The specification process apparently took a mere two months compared with a more usual 6-18 months historically.

Q3 Results

In the three months to end September 2014 the Group saw revenues up by 8.5% on the back of a 9% increase in passenger capacity, a slightly lower 8% growth in traffic, and a modest 0.4% increase in passenger unit revenues offset by an 8% drop in cargo revenues. In constant currency terms passenger unit revenues fell by 1%. Unit costs fell by 5.7% in constant currency terms, and by an impressive 4.5% excluding fuel. Group operating profits came in at €900m before exceptional items against €690m in the prior year period. Of this BA provided £484m (up by nearly 20% year on year), Iberia €162m (more than double that achieved in the prior year period, and on a similar adjusted operating margin to BA) while Vueling managed to generate €140m, similar to the previous year despite growing capacity by nearly 30% year on year.

For the nine months to end September total Group operating profits came in at €1.13bn up from €657m in the previous year. For the full year IAG expects to be able to produce operating profits of around €1.3bn.


IAG merged the cargo operations of British Airways and Iberia shortly after the merger in 2011 as an independent Group business brand of IAG Cargo. The combined operation is one of the top ten airline cargo businesses in the world (excluding the integrators), has a combined turnover of over €1bn, around a 4% global market share of air freight and serves some 250 destinations world-wide.

In presenting its sales message it states that IAG Cargo:

  • Offers more widebody capacity to the world’s top 120 air freight destinations than any other carrier;

  • By using a twice daily widebody airbridge to link London and Madrid it provides customers with unparalleled network linkage between Asia Pacific and Latin America;

  • Offers more same day connections via the UK for small consignments to and from Europe than any other carrier;

  • Offers more direct flights to key destinations in North America than any other airline, with an unrivalled 19 gateways in the US and over 47 flights per day;

  • With over 18 destinations, it has more flights from Europe to Latin America than any other carrier.

Integration of the operation is virtually complete. It will end up as a single brand, with one product portfolio, one management team and sales team incentivised to optimise Group results, one network and one distribution channel. As one of the first large scale system integration projects within the IAG Group, always a big headache, it is producing a single revenue management system providing inventory controls across the entire network.

It is the only one of the top ten freight carriers not to operate its own full-freighter fleet. BA had hitherto (from 2002) wet-leased a handful of 747Fs from GSS. These had provided the cargo business with 13% of its capacity but accounted for 25% of costs. In May 2014, however, it cancelled the agreement and signed a cooperation with fellow oneworld member Qatar to provide competitive full-freight lift through Doha (structurally to allow it preserve freight services to and from Hong Kong, which it described as the “jewel in the crown” of its freighter routes — and possibly the only one to make commercial sense). Cogently the company views the cargo market as inherently in a position of overcapacity and that from a corporate point of view it cannot justify the expenditure of capital on all-freight aircraft.

When it decided to get rid of the freighter fleet the management had been a little concerned that some customers would be upset. There is an argument that there are some types of cargo that will generate a yield premium for full freight operations — oversize cargo, dangerous goods and items forbidden for carriage on passenger aircraft. (This seems to be one of the reasons why Air France-KLM Cargo is retaining a few freighters — see Aviation Strategy, September 2014). However, IAG stated that the customer perception has been positive.

The resulting combined cargo entity appears to be an innovative operating model, somewhat removed from those operated by most of its competitors, and strongly focussed on value generation. Steve Gunning, CEO of IAG Cargo, presented a view of the various different business models adopted in the passenger airline business for air cargo operations (see table).

IAG Cargo profitability model
Cargo revenues
Direct costs  
Overheads (cargo related)
Fuel burn on pax aircraft
Non-attributable cost allocation
Overheads (non-cargo)
Capacity charge for pax aircraft
Note: ✓=yes; ✗=no; ∂=partial.

The simplest, and traditional, model (A) is where the passenger airline views cargo as purely peripheral to passenger operations but a “good idea” to gain the marginal dollar of revenue. Revenues are allocated to the cargo sales, but marginal costs are largely ignored. A more complicated model (B) — reflecting perhaps the set-up at IAG's main European competitors — attempts to provide a truer measure of the economic benefit. Here it assumes the costs directly attributable to operation of the cargo business, but also takes a share of Group overheads and a proportion of passenger aircraft operating costs, capital and overheads. Somewhat surprisingly, apparently neither of these two models take account of the marginal fuel burn related to the weight of the cargo on passenger aircraft. The IAG model in contrast does; but equally does not burden itself with the complexity of arguing with the passenger division an arbitrary charge for the passenger aircraft overheads.

British Airways

The recovery at BA and its plans to “Transform London” appears well on track. CEO Keith Williams pointed out that the airline's strategic position at Heathrow has significantly changed to its advantage. Since 2010, BA and its oneworld partners have gained share at the airport — and not just because of the acquisition of bmi. Since 2010 it has seen compound annual growth of 7% in the number of passengers carried through the airport, while non-oneworld airlines have seen their share decline. The acquisition of bmi allowed it to boost its share of the slots at Europe's prime gateway from 42% to over 52%; and importantly provided it with the leeway to add long-haul routes without closing short-haul feeder services.

The new generation aircraft now coming on stream are also helping: for example the introduction of the A380 on LHR-LAX has allowed it to move from three daily 747 flights to two daily A380s with a total reduction of 1% in the number of seats per day, but a richer seat mix (5% increase in premium, but 7% reduction in non-premium) and a total daily trip cost some 20% below the 747 operation. This releases a pair of slots for other long-haul.

At the same time it is focusing on optimising short-haul slot usage. In common with others it increasing seat density on the short-haul aircraft (and, surprisingly, after increasing the number of seats on board the A320s by 6% it has achieved improvements in customer satisfaction). The priority for short-haul is to develop the business network and feed the long-haul — but it is selectively targeting off-peak leisure routes to replace weak off-peak business flights.

After years of inefficient operations at its home airport, the recent moves are finally improving efficiency. Consolidating all operations into T5 and T3 has significantly helped crewing and ground handling. Withdrawal from T1 has allowed for a reduction in requirement for facilities at the airport — passenger lounges, offices, storage space and restrooms. With the introduction of pier T5C it has reduced the amount of remote stand services to below 5% of the total while all T3 services are now on pier. These have both helped aircraft utilisation, reducing the need for two aircraft for 2015 on a like-for-like basis. The completion of the T3-T5 baggage tunnel in 2015 will substantially improve transfers.

The company reiterated its target to achieve operating profits in 2015 of £1.3bn — on a 10% margin equivalent to the last peak in 2007/08.


Two years ago Iberia was in a dire state — severely loss-making and haemorrhaging cash. At the investor day CEO Luis Gallego stated that they had achieved the turnaround plan put forward in 2012: to stop the operating cash burn, give Iberia a competitive cost base for long term growth (by initially cutting capacity by 15% and a 25% cut in staffing), and to fund the entire process out of its own resources. The company achieved a positive operating margin in the first nine months of 2014 and states that it will generate operating profits for the full year. It intends to get to the 10% IAG Group target by 2017.

Along with the reduction in workforce (70% completed by end 2014), the company has managed to put in place a structural change in working practices — with salary reductions, a new entrant B scale for flight crew, an increase in flying hours and greater flexibility in shifts and schedules. By 2015 it estimates that the average employee unit cost per ASK will have fallen by 25% compared with 2012; by 2020 will be 35% below that level.

The CEO's presentation referred to Iberia's strong position as a leader on routes between Europe and Latin America. Much of this relies on the historic, cultural links between Spain and its former colonies. In Europe Spain has the largest number of LatAm foreign residents (1.4m compared with the next largest, Italy, with around 0.3m). Spain is the second largest foreign direct investor in the region after the US. 25% of the turnover of Spanish quoted companies is generated in Latin America. Although relatively weak on routes to Brazil, it maintains an overwhelming position on routes to the hispanophone territories. Its total bookings to the region in the twelve months to September were 1.9m, of which 57% were direct compared with its nearest competitors, Air France (1.2m, 45% direct), TAP (1.2m , 48% direct), and Lufthansa (0.9m, 42% direct). It claims a market share of 17.6% (IB and BA combined would produce a market share of 23%, a little ahead of AF-KL combined of 20%).


Alex Cruz, CEO of Vueling was a little sanguine. Vueling is the low-cost growth engine bought by IAG last year — it increased total capacity in 2014 by nearly 30%. As usual with such a high rate of expansion, profitability has been subdued — it is running with operating profitability little changed on last year. Moreover, Cruz pointed to an increasingly competitive environment in the sector in the next few years.

Ryanair and easyJet are returning to growth with their new aircraft delivery programmes kicking in soon, while norwegian after next year also resumes a high level of new aircraft deliveries in 2016. He presented figures estimating LCC carriers in Europe would grow by 5% next year but ramp up capacity by an average of 10% a year for the following three years. In addition, while Vueling was initially at the forefront of developing the LCC hybrid model, the other major players are also becoming more “sophisticated”. The notable move is from Ryanair, adopting its more “cuddly” approach but also adding allocated seating, business fares, GDS distribution and so forth.

The company maintains three pillars of attack and defence: cost discipline, premium service, and flexibility. On a stage length adjusted basis it has a unit cost base similar to easyJet and norwegian (but still nearly double Ryanair or Wizz). Its premium service is more redolent of a redesigned legacy carrier than the traditional LCC moving up-market: a (sort of) business-class product in the front four rows, with a dividing curtain, food and lounge access, network transfer at Barcelona and Rome; an FFP (connected with Avios); interline agreements (first with Qatar); code share agreements (one with BA signed in 2014); and on-board wi-fi.

As regards flexibility, while it plans to increase the fleet to 104 units next year and nearly 150 aircraft by 2020, it has significant opportunities to adjust deliveries and lease returns according to market developments. It adjusts to the inherent seasonality by leasing out aircraft in the winter season and wet leasing in in the peak summer (while planning heavy maintenance for the winter season).

It could be that IAG's acquisition of Vueling was an inspired competitive move: it enticed its two major competitors, AF-KL and LHAG, into thinking that an in-house low-cost carrier is a good idea. Their plans for capacity expansion are fraught with difficulties, and they will not compete directly with Vueling, which has established itself as the de facto flag-carrier of Catalonia, However, Ryanair has decided to attack head-to-head at Vueling’s new bases, Brussels, Rome, etc, putting Vueling’s ability to expand on a pan-European basis in doubt.


IAG is seemingly managing to live up to its promises to the capital markets to return to a value-enhancing level of profitability; what next? Group CEO Willie Walsh made a couple of intriguing comments: firstly, that the Group had established a senior executive succession plan (while almost in the same breath stating that this did not mean that he was planning to leave), and secondly that the IAG Group was a unique structure, uniquely designed to acquire and run different airline brands. The resultant question is: “which is the next acquisition?”

IAG share price
IAG share price Produced by GNUPLOT 4.6 patchlevel 3 150 200 250 300 350 400 450 500 2013 2014 GBp gnuplot_plot_1

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