IAG: Creating value through plug and play November 2018

At the beginning of November IAG held its annual capital markets day highlighting how well it was performing, and especially in comparison with peers. Management bemoaned the “unfairness” of the low rating that its shares attract on the stockmarkets. It has done a good job in creating value since its creation through the merger of British Airways and Iberia in 2011, augmented by successful acquisitions and integration of Vueling, Aer Lingus and bmi. Is this complaint justified? 

Both BA and Iberia were a bit late in the European consolidation game, but this did mean that they could create a structure for growth taking the best ideas from and avoiding the pitfalls of their major competitors Air France-KLM and Lufthansa Group. 

And IAG has a unique structure. The umbrella corporate organisation, IAG, maintains “parent neutrality”: there is an impartial treatment of individual branded airlines within the group. This is in complete contrast  to competitors in Europe (eg Lufthansa) where the main brand is dominant, or mergers in the US where subsidiary brands have been subsumed into a single operating brand.

The operating branded airlines are independently operated as separate units, but have to compete for capital application from the parent organisation. 

From the start, the group developed a platform of common services (cargo, FFP currency, maintenance, fleet, business services, IT). The idea behind it being that any future airline brand acquisitions could easily be “plugged in” to the structure with minimal disruption and maximum immediate synergies. 

IAG is the corporate parent. CEO Willie Walsh describes its role to set the long term vision for the group, define portfolio attractiveness, make the capital allocation decisions and exert vertical and horizontal influence across the group. He avers that the neutrality and independence of the corporate parent from the operating companies enables flexible, rapid and dispassionate decision making.

The airline operating companies define their own product strategies for their target customer segments, retaining a deep and continual understanding of their individual competitive environments. They are stand-alone profit centres (and independent credit entities). And he says that the portfolio of airline operating companies that the group has established “provides a good combination” of profitable businesses each with distinct and attractive market positioning and a diversified exposure to differing segments of the airline business. 

The four main hubs (London, Madrid, Dublin and Barcelona) are complementary on a geographical basis and, the company says, each has a clearly defined role in the total IAG system underpinned by a strong local market.

British Airways' position at London Heathrow is the jewel in the crown: London is the international gateway into Europe and the base of the strongest aviation market in Europe. Iberia at Madrid Barajas provides very strong cultural and transport links onto growing Latin American routes. Aer Lingus has a unique position in Dublin as the westernmost  major airport for access to the important Atlantic routes; strong cultural links to millions of Irish-Americans; US immigration pre-clearance; and a new runway due to open in 2021. Vueling at Barcelona is the de facto flag carrier for Catalonia. 

Walsh highlighted that since the creation of IAG in 2011, the group has delivered outstanding results. At the time of the merger there was much doubt over the group’s ability to generate the planned €400m synergies by 2015. He stated that, in the end, the total annual reported synergy from the combination of BA and Iberia reached €856m by that target year — however impossible it may be for an outside observer to work it out. 

He also emphasised that the group was able and committed to make tough choices. With minimal disruption (in comparison with some of its competitors) it was able to push through a 21% reduction in Iberia’s average head-count since 2012. 

Equally he was proud to show that the “plug-and-play” structure really works. Since acquisition by IAG the margins at Vueling improved by 5.9 percentage points and those at Aer Lingus by 9.1. Indeed at Aer Lingus since the acquisition by IAG in 2015, ex fuel unit costs have fallen by 18%, unit revenues by 9%, capacity increased by a third, operating margins and RoIC doubled. 

Indeed as a group IAG states that it has delivered an 11.5% reduction in ex-fuel units costs since the merger: an annual average decline of 1.5% in constant currency terms. 

As an example of the flexibility that this unique structure allows, Walsh referred to the launch of the latest airline in its portfolio: Level. Originally tagged as a “Next Generation Low Cost Carrier” the group Board approved the concept in September 2016. Tickets went on sale in March 2017 and the new carrier launched flights from Barcelona in June of that year with two A330s. In Summer 2018 it started long haul operations from Paris with another two A330s and short haul operations out of Vienna with four A321s.

Level is unusual: it is almost a virtual airline and seemingly totally customer-focused. Operations are provided by wet-leases from other group companies: Iberia provides the lift out of Barcelona as a sub-contractor, BA’s OpenSkies that from Paris, and a Vueling-owned Austrian AOC as a franchisee out of Vienna. The ethos is described as a maniacal focus on the core customer segment and on the cost base.

Meanwhile, Group CFO  Enrique Dupuy emphasised that IAG was providing superior returns on capital having exceeded its original target of 12% RoIC in the past four years (see charts) and its revised “sustainable” target of 15% in the past two. Moreover, IAG is generating average annual free cash flow of €2.5bn despite annual capex of a similar amount; and in the past four years has provided €2.7bn in cash returns to shareholders through dividends and share buybacks. 

He added that the structure of the group makes it far more resilient to weathering any potential downturn than the individual companies had been in 2008: a diverse portfolio of brands; more flexible fleet structure; strong balance sheet; greater proportion of LCC/value airline model weighting in the portfolio — now accounting for 25% of capacity. Indeed the group’s internal modelling suggests that were the 2008 GFC to hit now, profits would fall (by a third) but the group would remain profitable.

On most valuation metrics he pointed out that IAG is in the top quartile of companies in the FTSE100. And yet the share price is no higher than it was three years ago, with prospective valuation multiples (similar to Lufthansa and Air France-KLM) at a distinct discount to quoted airlines in the US, Latin America and LCC competitors in Europe.

But here’s the rub. Airlines are not a “must have” sector for global investors and are still viewed as cyclical beasts dependent on fuel, economy and politics. And the political aspects of Brexit are weighing heavily (see Aviation Strategy Sept 2018) — while Walsh remains sanguinely positive, there are serious questions of the EU’s future treatment of IAG’s “ownership and control” structure as a “European” airline. 

At least the UK has recently signed an open-skies bilateral agreement with the US to replace the USA-EU treaty when the UK leaves the EU. It apparently “grandfathers” current British operating airlines as British for the purpose of ownership and control. This helps not only IAG’s BA, but also Virgin Atlantic who will become majority-owned (and controlled?) by Delta once Branson sells an agreed 31% stake to Air France-KLM (in which Delta owns a 10% stake) in 2019.