IAG ready to take off

The acquisition of Air Europa, costing €2.4bn including debt, would make IAG the market-leading airline serving the South Atlantic from Europe. If cleared, the deal would be expected to complete in the second half of 2020. As well as gaining lucrative routes from the acquisition, based on past experience investors should be able to expect major cost savings. Indeed, Europa would be the fifth acquisition for IAG since its formation, which includes the purchase of assets from Monarch after its administration. 

IAG’s solid financial position means it can fund the deal with borrowings, while keeping net debt/cash profits (Ebitda) some way below its 1.8 times target. Importantly, IAG’s structure lends itself to consolidation. Its four airlines – British Airways, Iberia, Aer Lingus and Vueling – operate independently, but share central functions. Meanwhile, capital allocation decisions are made at group level. This has served IAG shareholders well since 2011 as measured by growth in return on invested capital (ROIC), with the group’s target to maintain ROIC at an industry-leading 15 per cent or more. 

Part of IAG’s success in raising ROIC has been thanks to its ability to cut costs. Between 2010 and 2018, cost per average seat kilometre, excluding fuel, has fallen 10.7 per cent and further reductions of 1 per cent a year are targeted in the three years to 2022. IAG thinks it can unlock another level of synergies by performing more core airline activities at the group level, including loyalty schemes, fleet management, sales and pricing. 

The competitive environment also appears to be becoming more favourable due to falling airline capacity growth. The industry experienced shock events in 2019, such as the collapse of Thomas Cook, which owned its own airline, and the grounding of Boeing’s 737 Max. IAG hopes to play the 737 situation to its advantage, having signed a letter of intent to buy 200 of the planes between 2023 and 2027 on very attractive terms.

Meanwhile, airlines across the board have been reining in growth plans in response to tough trading. For its part, in the past year IAG has reduced its capacity growth targets for 2022 by 13 per cent. This should mean a stronger pricing environment. IAG is well placed to benefit thanks to market-leading positions at its four flying hubs of London, Madrid, Barcelona and Dublin (in Dublin it leads in revenue terms, but not seats flown). IAG should also benefit from the financial strain being felt by its former bid target, Norwegian Shuttle Airlines. Norwegian has cut four North Atlantic budget routes, which should benefit IAG as European market leader.

A number of other issues could soon abate for IAG. The company has had to make substantial pension top-up payments over recent years, but all going to plan, these cash outflows should drop from about €700m in 2019 to €450 over the next three years, followed by €100m, then nothing by 2024. Industrial action has also been a problem in 2019, but there have been reported breakthroughs of late, although no official confirmation. Brexit clarity could also aid sentiment, as it may reduce the restrictions on the shares associated with rules of minimum 50 per cent ownership by EU approved nations. 

VALUATION VS PEERS

Source: S&P CapitalIQ