25-Feb-2015 4:05 PM

Aer Lingus grows FY operating profit, but needs further cost cuts. Meanwhile, IAG bid inches forward

Analysis

Aer Lingus grew its operating profit in 2014, although the net result fell into loss due to a one-off pension scheme payment. Unit revenues increased across the network, helped on European routes by modest capacity reduction, but also achieved on the North Atlantic in spite of double digit growth.

However, unit costs increased too, albeit a little more slowly than unit revenues, and have been rising for five years. In 2014, this was partly explained by costs of further long haul growth before assets are fully utilised. Nevertheless, Aer Lingus has rightly identified unit cost reduction as a priority to drive margin expansion.

This will be vital, regardless of the outcome of IAG's bid for Aer Lingus at EUR2.55 per share (EUR2.50 in cash and EUR0.05 in dividends). The Irish government, holder of 25% of the company, now seems to be inching towards the IAG deal. However, there could be a sticking point in its recent request that IAG extend beyond five years the commitments it has offered over the continued use of Aer Lingus' Heathrow slots on Irish routes.

Summary

Aer Lingus reported an operating profit increase of 18% in 2014, with revenues growing by 9.2% to €1,557 million.
The net result fell into a loss of €96 million due to a one-off pension scheme payment.
Unit costs increased, but at a slower rate than unit revenues, and Aer Lingus has identified unit cost reduction as a priority.
The Irish government, which holds a 25% stake in the company, is inching towards accepting IAG's bid for Aer Lingus, but has requested that IAG extend its commitments over the continued use of Aer Lingus' Heathrow slots on Irish routes beyond five years.
Aer Lingus' balance sheet remains strong, with gross cash higher than debt at €936 million.
Aer Lingus plans to grow its short haul load factor to be in line with its long haul network, achieving 10% growth in short haul RPKs in 2019 with no capacity increase.

Aer Lingus' operating profit up 18% in 2014, but margins have not taken off since the global financial crisis

In 2014, Aer Lingus' reported net result fell to a loss of EUR96 million, after a profit of EUR34 million in 2013. However, this loss was entirely due to a one-off EUR191 million payment to address pension scheme funding issues that had dogged the company and its industrial relations for a number of years.

The operating profit before exceptional items more closely reflects the underlying performance of the business and this increased by 18% to EUR72 million. Revenues grew by 9.2% to EUR1,557 million and the operating margin gained 0.3ppts to 4.6%.

See related reports:

Aer Lingus financial highlights 2013 and 2014

EUR million unless otherwise indicated	2013	2014	Change %
Total revenue	1,425.1	1,556.9	9.2%
Operating profit/(loss) (before exceptional items)	61.1	72.0	17.8%
Margin %	4.3%	4.6%	+0.3ppts
Net result	34.1	-95.8	-380.9%
Dividend per share (EUR cent)	4	5	25.0%
ASKs (million)	18,898	20,373	7.8%
Gross cash	898	936	4.2%
Debt	478	390	-18.3%
Net cash	420	545	29.9%

The pre-exceptional operating result of EUR72 million in 2014 was the highest since the global financial crisis, but short of the EUR79 million recorded for 2007. Its operating margin of 4.6% was towards the higher end of the range of 3.8% to 5.0% in which Aer Lingus has sat since the global financial crisis.

This puts Aer Lingus comfortably above the average margin for European airlines, typically in the 1% to 2% region over this period, but sort of its own 2007 peak of 6.1% and well below the 17.7% operating margin achieved by Ryanair in the calendar year 2014.

Aer Lingus - revenue and operating profit (before exceptional items), EUR million 2006 to 2014

Balance sheet strength: net cash increases

One of Aer Lingus' greatest strengths is its balance sheet, a legacy of its initial public offering in 2006 and relatively low levels of capital expenditure due to a high proportion of leased aircraft. Year end gross debt fell from EUR478 million in 2013 to EUR390 million in 2014 and gross cash continued to be higher than debt, at EUR936 million compared with EUR898 million a year earlier.

This cash balance is equivalent to 219 days of revenues, a very substantial cushion. Net cash increased from EUR420 million at end 2013 to EUR545 million at end 2014.

Aer Lingus - development of debt and cash 2006 to 2014, EUR million

ASKs were up 7.8%, driven by 23.8% growth on long haul

In 2014, Aer Lingus carried 9.8 million passengers, an increase of 1.5% versus 2013. Short haul passenger numbers declined by 1.0%, while long haul passenger numbers grew by 20.6% as a result of new routes and higher frequencies. Traffic carried by Aer Lingus Regional, operated by Stobart Air (formerly Aer Arann) under a franchise arrangement and helping to feed the long haul network, grew by 18% to 1.3 million. The total number passengers flying with the Aer Lingus brand increased by 3.2% to 11.1 million.

In total, ASKs were up 7.8% (down 1.5% on short haul, where capacity cuts were focused on the winter quarters, and up 23.8% on long haul) and load factor gained 0.6 ppts to 78.4%. This load factor was less than the AEA average for 2014 of 80.6%, reflecting the short haul network, where load factor was 75.6% (-0.1ppts).

On long haul, load factor improvement was not interrupted by the new routes and capacity growth: it gained 0.6ppts to 83.7% (the new San Francisco route saw load factor at more than 90 % within three months of launch).

Aer Lingus has identified a medium term opportunity to grow its short haul load factor to be broadly in line with that of its long haul network, thereby achieving 10% growth in short haul RPKs in 2019 with no capacity increase.

Aer Lingus passenger numbers 2006 to 2014 ('000)

Aer Lingus' revenue grew 9.2%

Revenue growth of 9.2%, faster than ASK growth, primarily reflected the growth of fare revenues, which accounted for 82% of the total and increased by 9.4%. This was driven by long haul, where fare revenue was up 28.4%, while short haul fare revenue was flat (+0.4%). The successful absorption of strong capacity growth on the Atlantic, with new services from Dublin to Toronto and San Francisco and increased frequencies to Boston and New York, was reflected in a 6.5% improvement in long haul fare revenue per passenger.

To some extent, this higher passenger yield on long haul was the result of longer average trip length on the Atlantic (up 3.4%), but the long haul network also enjoyed a 3.7% increase in fare revenue per ASK. All other things being equal, RASK typically falls as distance increases and so this performance demonstrates healthy demand and revenue management.

Retail revenue grew by 3.0% and retail revenue per passenger was up 1.5% to EUR19.14 as a result of bag fees, seat selection fees and Aer Lingus' new Plus product. Cargo revenue grew by 6.2%, with both volume and yield enjoying modest increases.

Other revenues, up by 45%, mainly reflect a full year of contract flying on UK domestic routes for Virgin Atlantic under the Little Red brand. This contract will progressively be discontinued this year, with all Little Red operations ceasing by Sep-2015.

In addition, in the Other revenue category, the contract with Novair, a tour operator for whom Aer Lingus operates a long haul service from Scandinavia to the Caribbean, will cease in winter 2015.

Aer Lingus revenues (EUR million) 2013 and 2014

	2013	2014	%Change yr on yr	% of 2014 revenue
Short haul fare revenue	789	791	0.3%	51%
Long haul fare revenue	381.6	490	28.4%	31%
Total fare revenue	1170.6	1281	9.4%	82%
Retail revenue	181.5	186.9	3.0%	12%
Cargo revenue	43.6	46.3	6.2%	3%
Other revenue	29.4	42.7	45.2%	3%
Total revenue	1425.1	1556.9	9.2%	100%

Analysis of fare revenue per passenger 2013 and 2014

	2013	2014	Change
Short haul rev/pax EUR	92.5	93.7	1.3%
Long haul rev/pax EUR	347.5	370.1	6.5%
Total fare rev/pax EUR	121.6	131.2	7.9%
Retail rev/pax EUR	18.85	19.14	1.5%

Costs rose 8.9%, largely due to international expansion

Operating costs were 8.9% higher in 2014 compared with 2014. This increase was higher than the growth in ASKs, but slightly less than the growth in revenue. Fuel costs grew by 5.8% and ex fuel costs were up 9.9%. Looking into 2015, Aer Lingus has hedged 90% of its fuel consumption at an average jet price of USD830/MT. This is higher than recent spot prices closer to USD600/MT, but compares favourably with Aer Lingus' average 2014 price of USD954/MT.

Labour costs grew by 8.4% year on year, due to increased headcount (+4.2%) in support of Aer Lingus' long haul expansion and contract flying activities, partly offset by departures under a voluntary redundancy scheme.

The sharp increase in operating lease costs (up 45.4%) was the result of three Boeing 757 aircraft deployed under 'damp' lease arrangements on the Atlantic and short haul aircraft deployed for Little Red. Ground operations and other costs jumped by 20.4%, mainly reflecting costs of catering, IFE and other items in connection with the long haul expansion, in addition to IT investments and pilot training fees.

Distribution charges grew by 15.3% as a result of higher CRS fees, credit card fees and advertising following industrial action in 1H and in support of new transatlantic routes and the new business class product.

Aer Lingus operating costs 2014 versus 2013, EUR million

	2013	2014	Change	% of 2014 total costs
Staff costs	277.4	300.6	8.4%	20.2%
Depreciation & amortisation	82.9	90.0	8.6%	6.1%
Aircraft operating lease costs	45.2	65.7	45.4%	4.4%
Fuel & oil costs	357.3	378.1	5.8%	25.5%
Maintenance expenses	68.4	71.6	4.7%	4.8%
Airport charges	298.7	315.1	5.5%	21.2%
Enroute charges	60.7	61.6	1.5%	4.1%
Distribution charges	47.0	54.2	15.3%	3.7%
Ground operations, catering & other operating costs	127.0	152.9	20.4%	10.3%
Other gains/losses	-0.6	-5.0	733.3%	-0.3%
Total operating costs	1364.0	1484.9	8.9%	100.0%
Ex fuel costs	1,006.70	1,106.80	9.9%	74.5%

A350 deliveries confirmed for 2018-2020

The Group's fleet has grown by five aircraft over the past 12 months to a total of 47, according to the CAPA Fleet Database (25-Feb-2015 versus 25-Feb-2014), with the addition of four Airbus A320s and one A330-200. A further A330 will be leased to operate the new Washington Dulles route.

The fleet details in the table below do not include three Boeing 757 aircraft operated on thinner routes on the Atlantic for Aer Lingus by ASL Aviation Group. A leased Boeing 767 has been secured for operation on the transatlantic in the peak summer season. For the future, Aer Lingus is considering the A321neo Long Range to augment and replace the 757.

Aer Lingus has confirmed deliveries of nine Airbus A350-900 aircraft (A350XWB or Regional variant) between 2018 and 2020, with three planned in each of these years. The new wide bodies will be used for growth and to replace A330s and offer a 20% unit cost advantage compared with the A330-200.

In the short haul fleet, Aer Lingus plans to replace A319s with A320 and A321 equipment in order to reduce unit costs, but is comfortable with operating its remaining fleet over a longer period to take advantage of lower lease rates. It expects to take advantage of new technology opportunistically in the early part of the next decade.

Aer Lingus Fleet Summary: aircraft in service as at 25-Feb-2014 and 25-Feb-2015

Aircraft	25-Feb-2014	25-Feb-2015	On Order*
Airbus A319-100	4	4	0
Airbus A320-200	29	33	0
Airbus A321-200	3	3	0
Airbus A330-200	2	3	0
Airbus A330-300	4	4	0
Airbus A350-900XWB	0	0	9
Total	42	47	9

RASK grew faster than CASK in 2014, but CASK continues an upward path

In 2014, Aer Lingus achieved a creditable increase in total revenue per ASK (RASK) of 1.3%, in spite of a modest increase in average trip length. This was achieved through small gains in both yield and load factor and reflects the strength of its commercial offering. The RASK increase was a little greater than the CASK increase, which was 1.0%, and this drove up the operating profit.

Nevertheless, the longer average trip length might have been expected to lead to a decrease in CASK, rather than the increase that Aer Lingus reported in 2014. Industrial action in 1H2014 lowered the operating result by EUR10 million, according to Aer Lingus, but the increase in CASK is mainly related to the ramp up of long haul activity. Costs associated with this expansion were incurred ahead of its operating at full capacity.

However, increasing ASK is not a new phenomenon. Fortunately, since its last reported operating loss in 2009, Aer Lingus has grown RASK by 35%, more than the 20% increase in CASK over the same period. However, half of this RASK increase came in 2010, when the market bounced back from the slump of the global recession.

Since 2010, RASK and CASK have increased more or less in step, reflected in broadly unchanged operating profit margins. Average trip length has also increased every year since 2010, a factor that would normally be associated with falling CASK (and RASK).

Aer Lingus - index of operating cost per ASK and total revenue per ASK (each indexed to 100 in 2009)

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2015 outlook: double digit long haul capacity growth, flat short haul, but no profit guidance

Due to restrictions imposed by the Irish Takeover Panel while Aer Lingus is under offer, the company is not giving 2015 profit guidance. Short haul capacity should be broadly stable for the year, with some peak season growth and some targeted cuts in the winter.

Transatlantic growth will continue with the launch of a Dublin-Washington Dulles service from May-2015 and frequency increases on existing routes including San Francisco, New York and Orlando. Long haul ASK growth will be 13% in the summer schedule.

Ireland's Minister for Transport, Paschal Donohoe and Aer Lingus' new CEO, Stephen Kavanagh will be among many CEOs and other senior executives at CAPA's Airlines in Transition Event to be held at Powerscourt near Dublin on 25/26 March - Click here for more information and to register

IAG's bid is supported by the Aer Lingus board, but the Irish government pushes for more assurances

The success of the growing North Atlantic network brought Aer Lingus to the attention of IAG and the offer would seem to present Aer Lingus with the opportunity to enhance this development.

The board of Aer Lingus supports the bid, which is subject to acceptance by the airline's two largest shareholders, Ryanair and the Irish government. Ryanair, the largest shareholder with a 30% stake, has not quite exhausted the legal process by which it seeking to overturn a decision by the UK Competition Commission ordering it to sell down to 5%. Nevertheless, it seems likely that Ryanair will eventually become a seller.

This puts the ball firmly in the court of the Irish government, owner of 25% of the airline. Opposition to IAG's bid from some unions and politicians has caused the government to think carefully before coming to a decision. Its concerns revolve mainly around connectivity between Ireland and London Heathrow, which offers far more extensive global connections than are available at Dublin. The impact on jobs at Aer Lingus is also a concern.

In order to address these concerns, IAG has offered commitments not to sell Aer Lingus' Heathrow slots without the Irish government's approval; not to change Aer Lingus' name, head office or incorporation in Ireland; and to operate the Heathrow slots on Irish routes for at least five years, including a specific commitment to three daily slots on Heathrow-Shannon four daily slots on Heathrow-Cork. IAG has pointed out that there are no such commitments in place currently. It has also highlighted its intention to grow Aer Lingus' development on the Atlantic, leading to job creation, although initially there would be some headcount reduction in central functions where there is duplication.

But the Irish government is pushing IAG for more.

In a statement on 24-Feb-2015, the government asked for more details and firm commitments from IAG on the transatlantic growth potential, including new routes. It also wants more details and firm commitments concerning other opportunities to grow at Cork and Shannon and the enhancement of the Knock-Gatwick service through the development of Aer Lingus' relationship with British Airways.

The government also asked for more details, including a timeframe, on the overall impact on employment at Aer Lingus, taking into account new jobs for pilots, engineers and ground staff as well as the rationalisation indicated.

Longer commitment on Heathrow slots sought by Irish government

The tone of the government's statement suggests that it is looking to create space for agreement in these areas. Outgoing Aer Lingus CEO Christoph Mueller told analysts on a conference call to discuss the 2015 results that the process had now reached the point where it was a "question of why not to accept the bid".

However, the government's additional request that IAG extend the period of commitments regarding Heathrow slots beyond the five years offered looks likely to be a point over which negotiations could stumble.

IAG CEO Willie Walsh has previously indicated that IAG would not improve on the timeframe for its slot commitments, as it was not prepared to lock itself into whatever price increases might be imposed in the future at Dublin, Shannon and Cork. Nevertheless, the prospects of the deal going ahead remain very much alive following this latest government statement, particularly if the government can use its influence to reassure IAG over future airport charges at the Irish airports served from Heathrow.

Meanwhile, CASK reduction and margin improvement are priorities for new Aer Lingus CEO

Whether or not Aer Lingus is acquired by IAG, it needs to redouble its efforts to improve its margins and, for this, the focus must be on CASK reduction. A strong balance sheet has enabled it to weather a number of economic storms, but it is a small player in a large consolidating market, with margins that are vulnerable to any major downturn.

Fortunately, Aer Lingus and its CEO designate Stephen Kavanagh (who succeeds Mr Mueller on 1-Mar-2015) understands this.

Following the resolution of the pension funding problem, the company is relaunching its CORE programme, targeting EUR40 million in cost savings by the end of 2016 (EUR10 million than the original target) in order to reduce unit costs and improve margins. A benchmarking exercise aimed at identifying further areas of improvement its also being conducted and new labour relations mechanisms are being established.

Mr Mueller leaves his successor with a challenging agenda, but also having achieved a notable legacy and some useful pointers in the right direction. Nevertheless, Mr Kavanagh will need to ensure that his workforce moves with him.

Recent and repeated profitability, together with the strong balance sheet and a sense that the government will always protect them, may not help to create the necessary sense of urgency among employees. However, Aer Lingus' long term future depends on it.