IAG Is Flying High

IAG are flying and here are the reasons why. The company has transformed itself into a larger and more complex business. However, the trans-Atlantic route still seems to be driving growth at the moment. IAG has generated a large amount of cash from its strongly rising operating cash flow. It is estimated by the market to be on a low prospective estimated price to earnings ratio and a high estimated dividend yield. There is also a significant asset backing which, taken into account, makes earnings look even more lowly valued. 

The International Consolidated Airline Group (not a name of sheer poetry but a rose that smells just as sweet) is on the path to becoming re-valued. For years when it was the original British airways the operationally and financial highly geared share, which never had enough cash left over with which to pay a dividend, was more of a speculation than an investment. After the successful merger with the Spanish flag carrier Iberia and recently absorbing Aer Lingus (with effect from 18 August last) it is less of a speculation and on the path to becoming a member of the dividend equity fraternity, which makes it a proper investment with a dividend to help support and govern the share price. Furthermore, it will attract income funds for the first time. In addition, it is crucially now a more diversified business with more options and greater flexibility as well as an operationally more efficient business.

The latest annual traffic figures

Last month’s traffic statistics for the company which were for February 2016 were gravity-defyingly good. Passengers per kilo mile rose 15.8%, in contrast to a 9.5% increase a year before in February 2015. Premium traffic increased 7.0% and capacity jumped 14% versus only half that rate of increase in February 2015. They were an excellent and revealing act for the full annual Group figures which were release shortly afterwards.

The annual results to 31 December 2015

The annual results, presented as usual in Euros, revealed the following strong progress:

North America and Europe were the strongest markets and the largest part of the group network with the highest passenger load factor. The smaller African and South American markets were impacted by the fall in crude oil prices in the case of the former market and the decline in local currency exchange values in the latter case.

Total passenger revenue moved higher by 14.2% to Euro 20.35 billion. Overall Group revenue, other than income from passenger services, increased 13.3% to Euro 22.85 billion. Following on from that, operating profit increased a truly stupendous 68% to 2.3 billion with an operating margin of 10.6% and basic earnings per share increased 52% to basic 73.5 cents a share.

Operating yardsticks

The crucial operating statistics – or ‘metrics’ as it is now fashionable to term such information – were as follows: available passenger seats per kilometre increased 8.2%; the usage of them by passengers was slightly down on the figure for the previous year at 80.4%; revenue per passenger ‘unit’ rose 5.4%; and finally, costs on the available seats per kilometre basis was 4.3% greater.

The cost of greatest interest is fuel cost. Analysing that demonstrates the new complexity of this now more diversified business. Fuel costs in general were reportedly up 1.6%. However, from deep in the thicket of the financial reporting we learn that on a unit cost basis the cost of fuel was 17.2% lower net of hedging costs and presumably before exchange rate adjustments relating to different parts of the operations. It seems that there was an adverse 12% foreign exchange impact during the year because of the cost in sterling terms of fuelling on the important trans-Atlantic runs. A more understandable economic figure is the actual consumption statistic which appears to have fallen by 2% because of the employment of more modern fuel efficient aircraft. The report speaks of new fleets of Boeing 787s and Airbus A380s.

Surprisingly, perhaps, total employee costs in the accounts were reported as being 13.4%. However, in economic terms, employee unit costs fell 3.5% against the background of total numbers increasing 2.3% to 60,802. Separately stated, employee productivity for the Group as a whole increased 5.8% with changes from airline to airline. The group average manpower figure was an improvement of 2.3%.

Cash and cash flow

The company has shown a strong up trend in operating cash flow since 2012, when annual operating cash flow was Euro 339 million. It has risen strongly each year since then. Last year it stood at Euro 1,968 million, up 5.7% on the year and getting on for six times the amount it was in 2012. Naturally, as net profits have grown they have become a greater contributor to operating cash while depreciation became less dominant, although it has grown with capital spending. In 2011, the depreciation charge was actually significantly larger than both net income and operating cash. Last year the depreciation charge supplied two thirds of operating cash and net income was actually 17% larger than operating cash. In other words, the company has more cash flow and it is more diversified, but net income is now crucial to its supply.

Balance sheet cash

Cash at the year end to December 2015 stood at Euro 2,909 million; 90% up on the previous year. That presages the transformation of IAG into a dividend paying share.

Capital expenditure

Up to and including 2013 capital spending was larger than the operating cash flow which helped to finance it. That was not true of 2014 and 2015 when it declined each year.

Total assets and net assets

Over the last five years total assets have grown Euro 19 billion to Euro 28 billion; assets attributable to ordinary shares (the equity) have increased much faster, by Euro 2.5 billion, or to be precise, by 82% in three years.

Financial gearing

Gearing is high at 165% of equity and 61% of capital. However, the management of British Airways have managed high gearing without disaster for many years. Moreover, I note that 86% of the debt in the balance sheet is designated as long term debt and thus not immediately vulnerable to changes in interest rates.

Where next?

The market consensus estimates are for revenue to increase this year (by 3.3%) and again next year (by 1.6%); it also estimates earnings per share in sterling terms to increase by 50% (which strikes me as heroic) to 110p, putting the shares on a prospective estimated price to earnings ratio of five times. It may be the case that airline companies, because of their high operating and financial gearing, should be on a low PER and high dividend yield but this rating looks very low. Moreover, it is accompanied by an estimated dividend yield of 3.9%, rising to 4.5% next year on the basis of a further consensus estimated 12% increase in earnings.