IAG:
Delivering on its promises November 2015

Four years ago each of the three major European networks carriers outlined strategic plans to restore profitability to levels that would provide returns to shareholders in excess of the cost of capital by 2015. In IAG’s case this represented a target operating profit of €1.5bn. In the intervening period each has suffered significant industrial action from recalcitrant unions but should have benefited from the decline in fuel prices and the  consolidation on the North Atlantic. Of the three only IAG looks to be able to produce results this year to achieve (indeed exceed) management plans of the time.

Indeed the group’s optimism has been so great that on the publication of this year’s nine months’ results that it has announced its first dividend to shareholders and at its subsequent capital markets day a significant upgrade in long term financial targets.

For the nine-month period to end September 2015, IAG saw revenues rise by 13% to €17.1bn, operating profits before exceptional items jump by 60% to €1.8bn (including a €45m contribution from Aer Lingus, acquired mid August) and net profits up by 70% to €1.7bn. This was on the back of a 7% increase in total capacity, a 1 percentage point increase in load factor (to 81.7%) and a 6% increase in unit revenues.

Falling fuel prices helped a little but, with high levels of hedging at rates higher than current spot prices, not as much as the headline figures would suggest. Total fuel costs were 3% up on the prior year period (and down 3% in nominal unit cost terms). (The fuel hedges will unwind in time — with a potential benefit of €2bn at current prices and exchange rates over the next three years. However, the group is expecting that 80-85% of this saving will be passed on to customers through yield dilution.)

The weakness of the Euro however had an overall positive impact of nearly €80m at the operating level; underlying unit revenues excluding currency were down by 3.3% while unit costs on the same basis down by 3.1%.

Each of the airlines performed well (see chart). British Airways’ operating profits were up by over 45% to €1.4bn (significantly aided by the strength of sterling), Iberia’s successful restructuring and resumption of growth generated operating profits of €196m up threefold from the prior year period, and the group’s high growth stand-alone LCC Vueling increased its operating profits by 24% to €173m.

The group guided to a full year operating profit (excluding Aer Lingus) of around €2.25bn and announced an initial interim dividend of €0.10 per share with a policy of a full year payout of 25% of net earnings.

Synergy benefits

At the time of the merger between BA and Iberia in 2010 the group had forecast combined synergies of €400m, split 35:65 between revenues and costs, before implementation costs of €36m. For 2015 IAG is saying that it will have significantly exceeded the original merger synergies targets with an overall benefit of over €800m at the operating level — cost savings nearly 20% higher than planned at €290m but revenue benefits nearly four times original expectations at €566m.

The revenue synergies are equivalent to a compound annual growth in unit revenues of 0.8% over the past five years and the increased value came from:

• combined fare structure
• code shares, cross selling and ancillaries
• revenue management best practices
• sales force and distribution cost savings
• launch of Avios single group loyalty currency
• single integrated cargo network

At the same time the cost synergies equate to a compound annual reduction in unit costs of 0.5% with additional cost savings deriving from measures such as:

• fleet: common specification and volume
• establishment of a group wide Global Business Services platform
• joint MRO planning and shared inventory
• procurement: single group solution and volume
• IT standardisation
• outsourced back office transactional activity

In his presentation at the group’s capital markets day CFO Enrique Dupuy illustrated these points on a chart entitled “Merger synergy program complete, target exceeded”. However, it became apparent that the group believes that it can continue to extract significant benefits from the programmes it has initiated well in excess of the synergies so far achieved.

Integrated Platform

The main reason for this optimism lies in the very structure that IAG established on the merger between BA and Iberia — one in which the operating airlines compete for group capital while maintaining their individual brand identities. Back office and brand-agnostic functions are put into a common group-wide organisation (which could also attract partners from outside the Group); all designed to be easily extensible as a “plug-and-play” framework, and scalable for any future acquisitions.

The result is what the group calls an “integrated platform”. This encompasses IAG Cargo, the loyalty programme currency Avios, Group Business Services (IT, procurement and finance), MRO/Fleet planning and Digital services. So far the group has nearly completed the cargo integration, is half way through integrating the FFPs but has further to go in the development of the other elements.

Fleet harmonisation

At last year’s capital markets day (see Aviation Strategy November 2014) the group outlined the way it had moved to common specification for its A320 acquisitions (of which it has orders and options for over 250). The aim is to build a fleet over time of harmonised aircraft that can quickly and easily be redeployed to any of the group’s operating airlines. In doing so the group has managed to reduce the aircraft weight by between 220kg and 470kg (depending on brand specification) by removing redundant items and moving to best-in-class (and lightest) seats. This will have a positive impact on operating fuel efficiency. In addition the group stated that it will be saving some €0.5-€1m per aircraft in acquisition cost through the proper specification of common avionics, cabin specific items, and better negotiating power with suppliers — even allowing for a small additional cost to retain a facility to allow for inter-brand flexibility.

By the end of this year the group will have 18 such A320s in the fleet; next year 30 and 109 by 2020 out of a total expected fleet then (ex Aer Lingus) of 359.

For the A330 deliveries the group has similarly designed a common specification and expects cost savings of about €1m per aircraft and weight savings of around a tonne. It is in the process of designing a common specification for the A350s, deliveries of which are due to start in 2018.

Global Business Services

The group’s new Global Business Services subsidiary is its “back-office” platform covering common IT, procurement and finance functions. Planned shortly after the BA/IB merger in 2011 its gestation has been gradual: outsourcing transactional finance activities in 2013; establishing the scope for GBS in 2014; and in the current year establishing its head office in Krakow, Poland (with business processing outsourced to centres in such as Chennai), it has implemented common finance systems and taken on the responsibility for tax, treasury and decision support activities.

Cost savings achieved so far have been itemised as a head count reduction of some 550 at BA and 410 at Iberia, with supplier contract renegotiations (airports, engines, fuel, credit cards and marketing/advertising) providing savings running into the “hundreds of millions” of Euros.

The group is using this transformation to remove legacy inefficiencies. It estimates that it is less than half way through the process (and only a quarter of the way regarding IT integration). But after the process is complete it expects to have an efficient, single, centrally managed back office based in Krakow: simplified systems operating on a single platform for processes and information; smaller connected teams focussed on business partnering. It also expects this will lead to a near 30% reduction in back-office manpower costs.

Business change can be a slow process. The group avers that there is significantly more to come in total benefits beyond the synergies already achieved: transferring additional finance administration to Krakow; integrating Aer Lingus, Avios, Iberia Express and Vueling processes; IT integration.

Upgraded targets

At the capital markets day the management announced a significant upgrade in long term planning goals. It is now targetting a real return on invested capital of 15% (up from 12% previously), which translates to a group operating margin target of 12%-15%. It is still planning organic capacity growth of 3%-4% a year between 2016 and 2020. On the financial side it now expects to generate an annual average EBITDAR of €5.6bn up around 10% from its previous assumptions.

It has also reduced the estimate of ongoing capital expenditure. Partly because of the drop in fuel prices it has slightly adjusted its fleet plan — having decided to prefer the exercise of options on old generation aircraft rather than more expensive new generation equipment; extend the operating life of 777-200s and 747-400s; judiciously leasing in second hand short- and long-haul aircraft.

It expects savings from the fleet harmonisation, but is also increasing the proportion of leased aircraft to owned from the current 30:70 ratio towards 40:60. As a result it points to a maximum annual capital expenditure of €2.5bn despite the fleet re-equipment programme and is expecting to be able to generate equity free cash flow of some €1.5-€2bn a year (and return a lot of that to shareholders).

The real consolidation model?

BA had been criticised by the financial markets for being late in the European consolidation game — and as IAG’s CEO Willie Walsh pointedly mentioned at the capital markets day, few in the the financial community believed that they could deliver the proposed synergies on the combination with Iberia that created IAG.

However, it may be sometimes best to let the first-movers in an industry development work away at their vision to discover a better way of doing things and learn from their mistakes. And IAG has shown that its integrated structure has allowed it to deliver on its promises and significantly outperform its main legacy competitors in Europe — Air France-KLM and Lufthansa.

Admittedly it has had the favourable tail winds of stronger economic performance in the UK and Spain (and Ireland), as well as the strength of sterling, that the other two have lacked. However, as the share price chart shows the stock markets have credited the group for delivering.

There are dangers. The industry cycle currently appears favourable; and it is probable that while traveller confidence remains positive the group will retain benefits from the decline in fuel prices. The integration of Aer Lingus should go well; but the management ought not be complacent.

Attention may now move to the next possible acquisition target. Finnair (another oneworld partner carrier) has been mooted as such, which would give IAG a "focus east" hub on the periphery of Europe. The markets are giving credit to Willie Walsh that any future deal will only be done if it creates returns for shareholders.