12-Feb-2013 3:35 PM

Aer Lingus: underlying profits rise for ‘Ireland’s civilised airline’, but beware any fall in RASK

Analysis

Last week (06-Feb-2013), Aer Lingus reported 2012 operating profit before exceptional items up almost 41% to EUR69 million, 5% above the consensus forecast of EUR66 million (according to Reuters) and its third successive positive annual operating result.

Aer Lingus is positioned between the LCCs and the full service carriers, styling itself as 'Ireland's civilised airline', but is this a sustainably profitable niche or just an attempt to make a virtue out of a necessity? It lacks the brand and product strength, network and frequent flyer programme to be a major network carrier and does not have a low enough cost base to be a genuine LCC. Its creditable profit recovery since 2009 owes more to market-driven unit revenue recovery, albeit aided by some intelligent management decisions, than it does to equally forceful action on unit costs.

Any slump in unit revenues, whether resulting from weak demand or over-supply in the market place could threaten its now well-established profitability. Assuming Aer Lingus does not end up in the hands of Ryanair, it may need to reconsider its strategy of avoiding the global alliances in the longer term, although its strong balance sheet should remain a good insurance policy in the near to medium term.

Summary

Aer Lingus reported a 41% increase in operating profit before exceptional items in 2012, marking its third consecutive year of positive operating results.
The airline's profitability is attributed to a recovery in unit revenues, driven by a 7% increase in yield per passenger.
Aer Lingus' strong balance sheet, with net cash of EUR377 million and a gross cash pile of EUR909 million, provides a

Key points of 2012 financial results

The growth in Aer Lingus' pre-exceptional operating profit was mainly due to a benign yield environment. Total capacity was virtually flat (ASKs +0.5%), while traffic grew 3.4%, helping to support yield per passenger (+7.0%). Exceptional costs totalling EUR26.5 million meant that pre-tax profit fell by 52%, but the underlying improving trend was reflected in management's proposal to increase the dividend from 3 cent to 4 cent per share. With net cash up from EUR318 million to EUR377 million and a gross cash pile of EUR909 million, Aer Lingus' balance sheet looks to be in rude health.

Aer Lingus financial highlights 2011 and 2012

EURm unless otherwise indicated	2011	2012	*Change %*
Total revenue	1,288.3	1,393.3	8.2%
Operating profit/(loss) (before exceptional items)	49.1	69.1	40.7%
Margin %	3.8%	5.0%	1.2pts
Exceptional items	37.2	(26.5)	N/A
Profit/(loss) before tax	84.4	40.6	(51.9%)
Dividend per share (cent)	3	4	33.3 %
ASKs (million)	18,593	18,685	0.5%
EURm	31 Dec 2011	31 Dec 2012	*Change %*
Gross cash	894.8	908.5	Up1.5%
Debt	577.2	531.6	Down 7.9%
Net cash	317.6	376.9	Up 18.7%
Equity	836.7	834.7	flat

Track record - profits stabilised, solid cash position

Since Christoph Mueller's appointment as CEO in 2009, Aer Lingus has seen operating profit recover and stabilise after heavy loses in 2008 and 2009. In addition, Aer Lingus has consolidated its cash position, putting a stop to the haemorrhaging that took place between 2006 and 2009, when it consumed EUR537 million in cash over three years.

Aer Lingus - operating profit (before exceptional items) 2006 to 2012, EURm

Aer Lingus - development of debt and cash 2006 to 2012, EURm

Passenger development

2012 saw the highest number of passengers flown on Aer Lingus services in a single year, with growth of 3.9% to 10.8 million (including Aer Lingus Regional, operated by Aer Arann, and the Madrid-Dulles codeshare with United Airlines).

Aer Lingus passenger numbers 2010 to 2012 (million)

As a city pair, Dublin to London is by far the most important market for Aer Lingus by seat capacity, with Dublin to Heathrow its most important airport to airport pair and Dublin to Gatwick its second most important. It grew its share of the Dublin to London market in 2012, as it did on the Transatlantic and in the total ex-Ireland market.

Aer Lingus market shares 2011 and 2012

Aer Lingus top 10 international routes by capacity (seats): 11-Feb-2013 to 17-Feb-2013

Aer Lingus top 10 hubs/bases/stations by capacity (seats): 11-Feb-2013 to 17-Feb-2013

Revenues aided by 7% yield/pax increases and successful United, JetBlue partnerships

Total revenues grew by 8.2% in 2012 to reach EUR1,393 million, driven by a 1.5% increase in passenger numbers and a 7.0% increase in yield per passenger. Aer Lingus remains a predominantly short-haul carrier, with 59% of its 2012 revenues deriving from short-haul fares. Nevertheless, long-haul fare revenue grew by almost 20% to reach one quarter of total revenues in 2012 and transatlantic capacity grew by 15%.

This perhaps reflects the success of partnerships with United and JetBlue and the attractions of US customs pre-clearance at both Dublin and Shannon.

Aer Lingus revenues 2011 and 2012

% of revenue	Revenue component	EURm 2011	EURm 2012	*%Change yr on yr*
59%	Short-haul fare revenue	781.0	816.3	4.5%
25%	Long-haul fare revenue	287.0	343.5	19.7%
83%	Passenger revenue	1,068.0	1,159.8	8.6%
13%	Retail revenue	168.7	176.5	4.6%
3%	Cargo revenue	43.0	45.7	6.3%
1%	Other revenue	8.6	11.3	31.4%
100%	Total revenue	1,288.3	1,393.3	*8.2%*

Yields per passenger grew 7% in 2012, reflecting tight capacity management both by Aer Lingus and in the market place at large. Yield growth was particularly strong on long-haul (up 9.1%). Short-haul yield per passenger grew by 3.8%, still healthy, but more modest compared with long-haul and the 6.5% increase enjoyed by rival (and would-be owner) Ryanair in the nine month period April to December 2012.

Analysis of fare revenues and yield per passenger 2011 and 2012

	2011	2012	Change
Short-haul revenue EUR m	781.0	816.3	4.5%
Long-haul revenue EUR m	287.0	343.5	19.7%
Total fare revenue EUR m	1068.0	1159.8	8.6%
Short-haul pax '000	8616	8674	0.7%
Short-haul rev/pax EUR	90.6	94.1	3.8%
Long-haul pax '000	897	979	9.1%
Long-haul rev/pax EUR	320.0	350.9	9.7%
Total pax '000	9513	9653	1.5%
Total fare rev/pax EUR	112.3	120.1	7.0%

In 2012, approximately 23% of Aer Lingus' total long-haul passenger traffic either connected from, or to, partner airlines services ( up from 18.5% in 2011). Interlining revenues and passenger volumes continued to grow, increasing by 8.8% and 5.5% respectively in 2012.

Cost savings target bettered; inflated by headcount growth, airport charges - and fuel

Operating costs (before exceptional items) grew by 6.9%, slower than the growth in revenues, in spite of a 24% increase in fuel costs. Staff costs grew by 2.4%, mainly due to headcount growth as wages remained frozen in the 'Greenfield' cost saving programme.

Airport costs grew more rapidly, by 7.1%, particularly due to price increases at London Heathrow and Spanish airports, and adverse currency movements.

Aer Lingus operating costs 2011 and 2012

EUR m	2011	2012	Change
Fuel	288.7	358.6	24.2%
Staff costs	260.5	266.7	2.4%
Airport charges	275.7	295.3	7.1%
Other operating costs	414.3	403.6	-2.6%
Total	1,239.2	1,324.2	6.9%

Aer Lingus - Exceptional credits/(charges) 2011 and 2012

EUR m	2012	2011
Restructuring provisions (incl. Greenfield)	(17.2)	3.1
Advisory fees related to Ryanair Offer	(9.9)	-
Asset impairments (incl. A320 held for sale)	(3.9)	-
Release of impairment provision	4.8	-
Gain on surrender of head office site lease	-	21.0
Reclassification of cash flow hedges	-	11.6
Loss on disposal of property, plant & equipment	-	(2.2)
Other	(0.3)	3.7
Total (charge)/credit	(26.5)	37.2

In 2012, Aer Lingus exceeded its savings target under its 'Greenfield' cost reduction programme, with a further EUR19.9 million to add to the cumulative total of EUR84.3 million achieved by the end of 2011. This brought the overall total to EUR104.2 million, ahead of the EUR97 million goal for the three year programme.

The initiatives undertaken to deliver the 2012 savings achieved included fuel management, overtime reduction, aircraft insurance savings, stock disposals and sourcing and supplier management improvements.

As with all such cost savings programmes initiated by company management teams, the achievement of targets is impossible to verify from the outside, since the onlooker does not know how much costs would have amounted to without the programme. Nevertheless, such programmes are a signal, both to the workforce and to shareholders, that management places a high priority on cost control and Aer Lingus says that it will continue to pursue cost saving opportunities even though the formal Greenfield programme has come to an end.

Aer Lingus - achievement against 'Greenfield' cost savings targets

Aer Lingus fuel hedges as at 31 December 2012

	Q1 2013 Forecast	Q2 2013 Forecast	Q3 2013 Forecast	Q4 2013 Forecast	2013 Forecast
Estimated burn ('000 tonnes)	89	125	130	103	447
% hedged	80%	65%	51%	36%	57%
Avg. hedged price USD/MT	1,011	1,001	987	955	994

Ryanair's bid: third time lucky, or another failed attempt?

Ryanair's current (third) attempt to acquire Aer Lingus demonstrates how keen its CEO Michael O'Leary is to buy Ireland's former flag carrier. Ryanair has offered what it calls "radical and unprecedented" remedies to the EU competition authorities in an attempt to gain approval for the deal. Even with these remedies, it is not certain that EU approval will be achieved, given the dominant position that the merged company would enjoy in many markets.

Moreover, given also that the Irish government, owner of a 25% stake in Aer Lingus, has repeatedly (since Ryanair's first bid in 2006) stated its opposition to selling to Ryanair, it is far from certain that the deal will ever close.

Seven out of Aer Lingus' top 10 routes and four out if its top 10 bases involve airports not served by Ryanair. This gives some credibility to Ryanair's claim that it would be able to use Aer Lingus to access airports that it would not serve in its own right. Nevertheless, competition concerns have scuppered the deal in the past, due to the strong combined position that the two would command at Dublin and from Ireland more broadly.

Aer Lingus is the leading carrier at Dublin airport, with almost 46% of seat capacity, ahead of Ryanair with 37%, giving the two airlines 82% between them.

Dublin Airport - % of capacity (seats) by carrier: 11-Feb-2013 to 17-Feb-2013

Dublin Airport - top 10 international routes by capacity (seats): 11-Feb-2013 to 17-Feb-2013

Aer Lingus and Ryanair share of capacity (seats) on key markets: 11-Feb-2013 to 17-Feb-2013

% of seats	Aer Lingus	Ryanair	Combined
Dublin to
London (all)	43.6	37.0	80.6
Manchester	53.3	46.7	100.0
Paris (all)	38.7	20.0	58.7
Birmingham	50.3	49.7	100.0
Amsterdam	100.0	0.0	100.0
Liverpool	0.0	100.0	100.0
Frankfurt (all)	30.9	11.2	42.1
Edinburgh	34.7	65.3	100.0
Brussels (all)	58.0	42.0	100.0
All destinations	46.0	37.0	82.0

Cork-London	55.1	44.9	100.0
Shannon-London	50.4	49.6	100.0

Ireland to W Europe	48.7	39.8	88.5
Ireland to E/C Europe	20.4	67.4	87.8

Aer Lingus' positioning: still low-ish cost and higher yield than LCCs, effective use of partnerships

Aer Lingus did not provide any guidance in terms of profit guidance for 2013, but Mr Mueller outlined areas of focus. A key priority for management remains the resolution of what it calls "the complex pension legacy", a reference to significant deficits on two pension schemes of which Aer Lingus employees are members. While Aer Lingus has no legal obligation to increase its contributions to these schemes, management appears keen to find a way to improve pension benefits for affected members, subject to shareholder approval, since it views this is an important industrial relations issue.

Turning to operational matters, transatlantic capacity will grow 15% in 2013, building on Dublin and Shannon's advantages in offering US customs pre-clearance, with at least two daily flights to all main gateways. Aer Lingus remains committed to its neutrality with respect to the major global alliances, preferring to open additional routes selectively in all important regions, using bilateral partnerships where necessary. It will continue to develop its regional business through a franchise agreement with Aer Arann, using the latter's ATR fleet to serve lower capacity routes and to add feed to the transatlantic network. Its recent agreement to operate short-haul services on behalf of Virgin Atlantic may lead to similar commercial agreements with other customer airlines.

Aer Lingus is solidly positioned between the LCCs and the full service carriers, with a relatively low-cost profile. A pure LCC model was never going to be sustainable since Aer Lingus cannot access deeply discount-priced aircraft and must carry the burden of legacy costs stemming from its seniority list and pensions. At the same time, its geographic positioning, relatively small domestic market (in particular the business market) and the presence of ultra low fare competition from Ryanair make a full service model uncompetitive.

On short-haul, it offers fares that are generally competitive compared with the major full service carriers, but which are more expensive than true LCCs. Its short-haul average fare per passenger of EUR94 compares with Ryanair at EUR47 in calendar 2012. On long-haul, it offers a network of US gateway cities and access beyond these gateways through codeshare partners, but, while its fares are competitive and US customs pre-clearance is an advantage, it is a niche player with a limited network and a sub-critical mass frequent flyer programme.

Unit revenue recovery has been the key to profit recovery

Management has very effectively focused on costs since the global financial crisis, but the recovery in operating profits is really due to the recovery in unit revenues. The chart below shows that unit costs (operating cost per ASK) have risen since 2009, but unit revenues have risen faster. The fall in labour costs (down EUR45 million since 2009) has been offset by increases in airport and en route charges (up EUR46 million since 2009) and fuel costs have risen EUR27 million over the same period.

In spite of management's cost initiatives, Aer Lingus' profitability remains vulnerable to any slump in yields. Its strong cash position, however, should help to cushion the impact of any fall in profits, at least in the near to medium term.

Aer Lingus - index of operating cost per ASK and fare revenues per ASK (each indexed to 100 in 2009), 2006 to 2012