IAG: mostly grounded
but shareholders mostly supportive September 2020

When Willie Walsh announced, at the beginning of January, that he intended to retire from his post as Chief Executive at International Consolidated Airlines Group, he must have thought that he would have been doing so at the peak of a long and successful career.

He had started as a cadet pilot at Aer Lingus aged 17, took over the reigns as CEO of the Irish flag carrier in 2001 and moved to take on the same role at British Airways in 2005. IAG, formed in 2011 from the merger of British Airways and Iberia, had grown under his leadership organically and by acquisition (of Vueling, Aer Lingus, British Midland and Monarch slots) to become the most profitable of the three top European legacy airline groups, albeit third behind Lufthansa and Air France-KLM in terms of total revenues.

In each of the three years leading up to the end of 2019, the group had achieved underlying operating margins of around 13% and returns on invested capital of 15%-17% — above the targets the group had set itself at the time of the merger.

But then, just a matter of weeks after he made his announcement came the crisis of the global Covid-19 pandemic, a virtual grounding of air travel worldwide and a desperate hunt for cash and liquidity.

Here IAG was in better shape than many. It had built a strong balance sheet, and although it had returned funds to shareholders in the good years, it had done so prudently and had not been beguiled into borrowing money merely to fund investment banks' fondness for share buybacks. Over the five years to end 2019, IAG had returned over €4bn to shareholders providing them with compound annual average total returns of 8%. It ended 2019 with cash liquidity of €8.6bn (34% of 2019 annual revenues), net debt to EBITDA of 1.25 (compared with an internal target ceiling of 1.8x) and investment grade ratings from Moody’s and Standard and Poors.

IAG had built a lot of flexibility into its fleet structure. At the end of 2019 the 600 strong fleet had an average age of 11.5 years; and, over the the next three years to 2022, 131 of the 200 long haul aircraft and 63 of the 398 short haul aircraft would approach the end of their useful lives. At the same time another 200 leased aircraft would have their leases coming up for renewal over that period; at the end of 2019 the group had planned only to renew the leases on 75 of these.

When the crisis hit fully in March and countries round the world effectively closed their borders, the group reacted decisively. It grounded 70% of its fleet, cut passenger capacity by 95% and implemented emergency measures to reduce cash spending — including cancelling the shareholder final dividend announced for 2019 — and delayed Walsh’s retirement to September.

It took advantage of the wage support schemes where it could. It used the UK’s Coronavirus Job Retention Scheme (CJRS) to furlough 22,000 staff (over half the workforce) at British Airways, Spain’s Expediente de Regulación Temporal de Empleo (ERTE) for 18,000 employees at Iberia and Vueling, and Ireland’s Temporary Wage Subsidy Scheme (TWSS) for 4,000 at Aer Lingus. In total affecting over 80% of the group’s head count this brought in a modest €270m in the first half of the year.

IAG shied away from strong sector-specific government support although it did qualify for and took advantage of the UK’s Covid Corporate Financing Facility (CCFF) with British Airways issuing the maximum permitted £300m commercial paper to HM Treasury and the Bank of England. In Spain, Iberia and Vueling entered into syndicated financing agreements respectively for €750m and €260m guaranteed by the Instituto de Crédito Oficial (ICO).

Willie Walsh over the years has been strongly opposed to state aid for airlines. On a recent webinar hosted by Eurocontrol, he pointed out that he was adamantly against governments' bailing out failed airlines (citing Alitalia in particular), but that support for well-managed carriers, such as Lufthansa, “who had entered this challenging position through no fault of their own” was fair. At the same time he noted that the major part of the current round of state support was in debt which had to be repaid, and that extrication from the support will be difficult.

As for all airlines round the world, IAG’s financial performance in 2020 has been dire. In the first six months to end June, passenger numbers were down by 64% from prior year levels; capacity in ASK down by 56% (and 90% in the second quarter); revenues fell by a similar percentage to €5.3bn; and it recorded an underlying operating loss of €1.9bn reversing a €1.1bn profit for the same period in 2019.

There was one bright point: cargo revenue was actually up 11% for the half year, and over 30% up in the second quarter — its best ever for cargo.

But when faced with an existential crisis these numbers are almost irrelevant and all focus has been on stemming the cash outflow and ensuring sufficient liquidity to last through the crisis. And it must have been depressing to have to state in the half year results that “a material uncertainty existed that may have cast doubt on the group’s ability to continue as a going concern”.

The group ended the half year with cash liquidity of €8.1bn, slightly down on that at the start of the year — but this was before the receipt of cash from a €380m sale and leaseback of five aircraft and £750m presale of frequent flyer points to American Express. But debt stood at 4.2x EBITDA (on an annual trailing basis) — reflecting the increase in debt and collapse of earnings. In September it concluded an emergency three for two rights issue to raise €2.7bn (fully supported by its 25% shareholder Qatar Airways, who itself has just received a $2bn injection from its owner).

Future size and shape

Where will IAG go from here? In his talk with Eurocontrol Willie Walsh forcefully said that the industry is “never going to get back to the way it was”. And the measures he oversaw since March, to be continued by his successor Luis Gallego, point to a significantly smaller group.

Along with temporarily grounding a large part of the fleet in the second quarter, the group accelerated the retirement of older, less fuel-efficient aircraft. British Airways retired its entire fleet of 32 ancient 747s, and Iberia its 15 A340s, and there were a further 20 narrow body aircraft that could be retired early without significant waste of useful operating life. There were 20 aircraft on plan to be returned to lessors at the end of their leases in the current year — and a further 42 and 54 whose leases expire respectively in 2021 and 2022 and which it could choose to return (it has probably negotiated the deferral of monthly lease payments).

It has also renegotiated planned deliveries of its aircraft on order from manufacturers, reducing the delivery of new aircraft by 68 units (from 143 to 75) between 2020 and 2022. 38 aircraft are now scheduled for delivery in 2020, 15 in 2021 and 22 units in 2022. This will help reduce group capex by more than half over the next two years (to €1.9bn and €2.4bn from €4.3bn and €5.7bn respectively).

All the airlines in the group are implementing restructuring plans to reduce staffing levels and improve wage productivity. At British Airways it expects that up to 13,000 staff could be made redundant and that most of the company’s 38,000 UK based employees could be affected by the restructuring. Over 8,000 had already left the business by the end of August, and BA had concluded agreements with its pilots, engineers and Heathrow customer service staff. Negotiations with the cabin crew have been a little more difficult.

Aer Lingus has announced plans to make 500 jobs redundant (more than 10% of its workforce).

In Spain, things are a little more complex (Iberia went through a massive job reduction programme eight years ago), and the ERTE job support programmes require positions to be maintained for the duration of the crisis. But the group states that both of the Spanish airlines “have held regular meetings with the main labour representatives to inform them of the ongoing situation and the plans that the companies are developing to adapt their cost base to the new post-COVID capacity and demand environment”.

Meanwhile Level has closed its Vienna based AOC, and OpenSkies (which operated Level’s services out of Paris Orly) is trying to work its way through the French employment laws to close its operations there.

Unique strengths

IAG has a unique corporate model in the airline industry. When it was formed in 2011 it could learn from the mistakes that British Airways and Iberia identified in the structures created by the merger of Air France and KLM in 2004, and acquisitions by Lufthansa (of Swiss and Austrian) in subsequent years to form the Lufthansa Group.

It is based on an independent corporate parent company which owns a portfolio of branded airlines and a common integrated platform to service its operations. The parent company makes decision about capital allocations to its airlines based on strict return criteria and exerts influence across the group to maximise returns.

The parent company is also responsible for setting the long-term vision for the Group. Its independence from the operating companies it sees as allowing it “objective, flexible and rapid decision-making” and enabling it to “implement a cohesive long-term vision for the Group”.

Each of the IAG airlines is a standalone profit centre, with an independent credit identity and its own management team and board of directors. As a result, each airline retains its own brand and individual cultural identity, focusing on meeting the needs of its target customers and differentiating itself from its competitors.

British Airways is a premium network carrier based in the largest aviation market in Europe — the UK — where the group had a 31% share of estimated revenues and 23% of the passengers, some way ahead of its nearest competitor easyJet (see chart). It relies London’s strength as a true O&D market — in normal times London would feature in ten of the world’s top 12 long haul origin and destination markets.

Because of this it may be less reliant on hub transfer traffic than some of its competitors — although the hub network has been an important part of its strategy.

It has a leading position on the North Atlantic, but its antitrust immunised joint venture (including Iberia, Aer Lingus and Finnair) is with American — the weakest of the top three US carriers. As a premium carrier it is dependent on corporate and premium travel — and we estimate to a much larger extent than that suggested by the figures for the group in the chart, (premium: 27% of revenues; corporate deals: 13%). Both these segments are possibly going to take a long time to recover. But one saving grace is that the prospect for Heathrow’s third runway will now be even further away.

Iberia as a network carrier has a strong position on the South Atlantic — the group had an estimated 19% of the revenues on routes between Europe and South America and Caribbean, slightly behind Air France-KLM. At the end of 2019 it had agreed to acquire Air Europa from Globalia (Spain’s largest tourism group) which being its next largest competitor in Madrid would consolidate its position at Barajas airport and give it the leading position to Latin America. It is still saying that it expects to complete the acquisition towards the end of 2020, although the eventual deal will no doubt be well below the originally agreed €1bn cash.

Iberia has a reasonable domestic market — a segment that is likely to recover from the crisis sooner — although this has been under pressure from the development of the high speed train network. It also depends on connecting flight in Madrid, (but to a lesser extent than British Airways on premium traffic) to make sense of its long haul routes, but there is a substantial level of VFR and cultural traffic between Spain and the hispanophonic countries of South America, which could also be at the forefront of a recovery in demand.

The acquisition of Air Europa still (probably) makes long-term strategic sense. It was the largest independent airline in Spain mainly flying domestic and intercontinental routes in the Spain-Latin America market where IAG’s ambitions had been thwarted when LATAM (currently in Chapter 11 protection) switched allegiance from oneworld to Delta (and SkyTeam) in 2019, and provided a strengthened position particularly in Brazil. Strategically the acquisition mirrors the acquisitions by British Airways of British Caledonian, Dan Air and bmi that allowed it consistently to build market share in London. At the time of the announcement, IAG had described Air Europa’s brand positioning as that of a “value” brand between full service and low cost.

Aer Lingus has 31% of the revenues and passengers at its home base in Dublin, although it is in second place behind Ryanair in the numbers of passengers carried. With a smaller, but noticeable presence on routes into North America, it had in recent years developed Dublin increasingly as a transfer hub, and in particular attracting what IAG refers to those looking for “frugal fun”. However, it also initiated plans to use the A321neoXLR — it recently took delivery of the first of a planned fleet of eight due by the beginning of 2021 to replace former leased 757s (and it has another six on order). These are designed to allow it efficiently to access smaller markets in the US and target the hundreds of millions of US nationals who identify as Irish-American.

Vueling is Europe’s third largest LCC operator. Based in Barcelona (as the de facto flag carrier of Catalonia) it had a leading position with 38% of the passenger throughput and 28% of the revenues, well ahead of its next largest competitor Ryanair. It also operates secondary bases in Rome and Paris Orly, and 14 airports in Spain. It is mostly a point-to-point operator (but has tried to market Barcelona as a transfer hub) with a single aircraft type adhering to the LCC “KISS” principle.

Level is the newest airline in the portfolio. Established as a long haul low cost operation with a fleet of three A330s to counter what may have been seen as the threat from Norwegian, it then expanded into short haul operations in the competitive Vienna market using aircraft from Vueling. These have now closed and it has retrenched in the crisis to operations from Barcelona. Immaterial in a group context, it is a possible future platform for a new normal in long haul flying. It could equally be closed.

Walsh’s legacy

Willie Walsh has now retired and handed over the reins to Luis Gallego. He has left him with a high quality company but one stuck in the worst crisis the industry has ever seen. However, IAG is (relatively) well capitalised and has the support of shareholders. It is one of the few unfettered by Government aid. And it comes with an established core concept of allocating capital among constituent airlines purely on the basis of expected returns.