IAG: capital efficiency can help a European legacy airline group to "show me the money"

ROIC is a better way to compare profitability than simple margin comparison

It is useful to re-cap what is meant by return on invested capital (ROIC) - the profit generated as a percentage of the capital invested in the business - and to review the importance of capital efficiency.

ROIC is a relatively simple concept, although there are many ways to calculate it. Central to the concept is the idea that a profit figure needs to be calibrated by reference to the scale of the business generating that profit.

Return on sales, more commonly known as profit margin (profit as a percentage of sales), is often used to rank the profitability of businesses. This is an important measure, since it takes account of the size of companies' revenues and for companies in the same line of business, but of different sizes, profit margin gives a fair measure of their relative success.

The importance of capital efficiency

However, profit margin really only shows half of the picture, especially when comparing companies in different industries, or even different segments of the same industry. The other half of the picture is a measure known as asset turn, which is the company's annual sales divided by the value of its assets (or capital).

Usually expressed as a multiple, asset turn says how many times a year the company generates revenue equal to the value of its assets. It is a measure of capital efficiency. Businesses that require a lot of capital to generate revenue have low asset turn, and are called capital intensive. Return on invested capital is the product of profit margin and asset turn.

Return on invested capital = Profit margin x asset turn
Or, to give profit margin and asset turn their full definitions:
Return on invested capital = (profit/sales) x (sales/capital)

Capital intensive businesses (those with low asset turn) need to generate higher profit margins than those that are less capital intensive in order to earn the same return on invested capital. Much commentary and analysis concerning the relative financial performance of businesses concentrates on margins, not least because they are relatively easy to calculate.

Moreover, a high degree of management attention also concentrates on margins, and this can lead to insufficient attention being given to asset turn. This can be a problem in the airline industry, which is typically both low margin and capital intensive. One way to improve margins is to invest in assets with more cost-efficient new technology. However, this risks lowering asset turn, and may lower return on invested capital if the margin improvement is not sufficient.

In addition to profit margins, therefore, it is also important to consider capital efficiency. If existing assets can be more efficiently utilised to generate more sales, this may not have a major impact on margins but it will improve return on invested capital.

IAG annual capital expenditure cap is lowered

More airlines than ever before are talking about the need to focus on ROIC. The financial concept of capital efficiency is starting to gain greater currency in the airline industry, but IAG's recent presentations at its capital markets day demonstrated that it has embedded the fundamentals of it more deeply than many of its rivals in Europe. The management teams of each of its operating airlines talked specifically about steps to increase capital efficiency.

IAG has higher margins than Lufthansa Group and Air France-KLM, but its added focus on capital efficiency gives it a second advantage in reaching higher rates of return on invested capital.

See related report: IAG again beats Lufthansa & Air France-KLM in 3Q2015, but unit revenue is weak

As a result of its focus on capital efficiency, IAG has been able to set a EUR2.5 billion cap on planned annual capital expenditure for the period 2016-2020. This is higher than in recent years, but the cap is less than that implied by its previous capex target range of EUR2 billion to EUR3 billion for 2016-2020.

See related reports:

IAG sets ambitious goals for 2016-20, including regular dividend, and declares its confidence

IAG's aircraft orders are like waiting for a bus. Three arrive at the same time.

IAG centralises its capital procurement

Although the strength of the USD (the principal currency for IAG's capex, since aircraft are priced in USD) inflates the value of its investment when translated into EUR, IAG has implemented a number of initiatives to contain and lower its capex.

These initiatives start with centralised capital procurement, whereby IAG orders aircraft at the group level, sometimes with a specific operating airline in mind at the time of the order, and sometimes for deployment by whichever airline will have the need at the time of delivery. This approach gives the price benefits of purchasing in scale, and the flexibility to assign aircraft according to demand conditions.

Balance between operating efficiency and capital discipline

IAG has also thought carefully about the mix of old legacy technology and new generation aircraft in its fleet. Its recent decision to exercise options over Airbus A330 aircraft (two A330-200s and two A330-300s) for Iberia and Aer Lingus, in preference to exercising its options over A350 and Boeing 787 aircraft, illustrates this thinking.

IAG has outstanding orders and options for the two new generation aircraft types, but on this occasion it preferred to acquire lower priced current generation technology.

IAG Fleet Plan (excluding Aer Lingus) 2016 to 2020: ASK by aircraft category

Source: IAG Capital Markets Day presentation 6-Nov-2015

This decision by IAG may have been influenced partly by lower fuel prices, but is part of a broader approach that attempts to balance operating efficiency against capital discipline. According to the CAPA Fleet Database, the IAG fleet's average age is 11.1 years as at 9-Nov-2015. Its 2016-2020 fleet plan will keep the average age in the range 11-12 years.

Aircraft life extensions improve capital efficiency

This approach has also led IAG to extend the life of older aircraft types, such as the 777-200 and 747-400, both operated by British Airways. According to the CAPA Fleet Database, BA's fleet of 46 Boeing 777-200s has an average age of 16.2 years, but IAG's fleet plan will maintain the same number at least through to the end of 2020, when the oldest will be more than 25 years old. Its plan will extend the life of its 777 fleet to 30 years.

BA's 747 fleet, with an average age of almost 20 years, has reduced in number from 43 at the end of 2014 to 39 as at 9-Nov-2015, and will reduce further to 36 in 2016, and then to 19 at the end of 2020.

Many of these aircraft are fully depreciated, and this helps to offset their lower fuel efficiency compared with more modern types. Cabin refurbishment involves a modest level of capital investment by comparison with buying new aircraft, but can extend the life of these assets, whose low book value can then generate a high asset turn.

British Airways wide body fleet by aircraft category at year end 2014 to 2020

Source: IAG Capital Markets Day presentation 6-Nov-2015

Changes to seat configuration can generate more sales from an aircraft

Capital efficiency - increasing the level of sales from an aircraft - can be further enhanced through changes to seat configuration. This can be done either by increasing the total number of seats (densification) or by adjusting the proportion of high yield premium seats on appropriate routes.

If applied intelligently, seat densification can grow sales without growing the asset base, and also reduce unit cost.

IAG is adding 10% more seats to BA's 777-200 aircraft by reducing the number of business class seats, while the removal of first class will add 25% more seats to its 777-200ER fleet. Iberia's A330-300 aircraft are undergoing a reduction in business class seat numbers from 36 to 29, while a new premium economy cabin will add 21 seats. Similarly, Iberia's A340-600 business class will fall from 46 to 36 seats, but premium economy will add 23 seats.

Increasing the number of premium seats, but reducing the total number of seats, is the opposite of seat densification. It is aimed at generating higher revenues from flights to destinations with strong demand from business class travellers - most notably, to New York.

BA has, for a number of years, operated a proportion of its 747 fleet under a so-called 'High J' configuration: 84 premium seats (of which 70 are business class), 30 premium economy and 177 economy class.

BA recently started to modify 18 of its 747 aircraft into a 'Super High J' configuration, adding an additional 16 business class seats, and taking the premium total to 100 (of which 86 are in business class), whereas the number of economy seats is reduced from 177 to 145. The total number of seats on these 'Super High J' aircraft will now be 275, versus 291 in the original 'High J' configuration (and compared with 337 seats on the 'Mid J' 747s).

BA's seat densification programme for its short haul Airbus fleet is nearly complete, and will yield an increase of around 1.8 million seats pa, equivalent to seven narrow body aircraft. In addition, an up-gauging of its Airbus fleet will cut the number of A319s from 44 in 2015 to 28 in 2020, while the number of A320s will grow from 62 to 83, and the A321 fleet will increase from 11 to 23 over the same period.

Vueling is also up-gauging its fleet, taking the number of A321s in its fleet from five at 9-Nov-2015 to ten by the end of 2016.

Fleet harmonisation of aircraft types used by different IAG airlines yields significant savings

Fleet harmonisation is another way in which IAG is increasing its capital efficiency. It has now standardised the specification of its A320 fleet across BA, Iberia, Iberia Express and Vueling.

This process has involved three operational dimensions: cabin configuration (including the ability to reconfigure seat numbers for redeployment by different operating airlines); avionics and systems; and emergency equipment.

The standardised A320 specification is now being rolled out across the fleets of the different operating airlines. IAG had two harmonised A320 family aircraft at the end of 2014 and expects to have 18 at the end of 2015, 30 at the end of 2016 (of which 20 A320 and 10 A321) and 109 at the end of 2020 (24 A320, 10 A321 and 75 neo variants).

IAG estimates that the cost saving from this A320 harmonisation is EUR0.5 million to EUR1 million per aircraft. It puts the cost saving from a similar process for Iberia's A330-200 fleet, to be delivered from Dec-2015, at around EUR3 million per aircraft. That conversion is to 288 seats (19 business class and 269 economy).

IAG is currently working on a standard specification for its A350 orders, to be delivered from 2018 and operated by all three of its long haul brands (BA, Iberia and Aer Lingus). It has yet to finalise the full specification, but at its capital markets day IAG said that its A350 seat configuration would be "one of the best in class versus known competitors", suggesting that it will have more than 364 seats on its A350-900 (the competitor range is 280 to 364 seats, according to IAG's research).

Operating lease share of IAG fleet to grow from 30% to 40%

A further method for keeping capital expenditure under control is to increase the share of aircraft acquired under operating leases. IAG aims to increase this proportion from 30% to 40%.

Although increasing the number of aircraft under operating lease provides cash savings in capital investment, it does not change the total amount of capital tied up in the business - it just changes the legal ownership of that capital. Most analysts would make an adjustment to include such off balance sheet assets in the capital base of an airline when assessing its financial performance. Nevertheless, operating leases can also increase an airline's flexibility over its fleet size, and this is another tool in fine tuning its capital efficiency.

IAG's asset growth will be slower than ASK growth

As a result of its initiatives to keep its annual capital investment at less than EUR2.5 billion from 2016 to 2020, IAG expects its asset value to grow at an average of 3% pa, compared with group ASK growth at the slightly higher rate of 3% to 4% pa (excluding Aer Lingus).

ASK growth will vary by airline, with BA growing at 2% to 3% pa, Iberia at 7% pa and Vueling at 10% pa in the period 2016-2020. Aer Lingus currently plans growth of 7.7% pa, but its plans are not yet finalised and integrated into IAG's planning.

IAG raises its margin and ROIC targets for 2016-2020

IAG has increased its long term financial goals for 2016-2020 from those set at its 2014 capital markets day.

Its operating margin target range is now 12% to 15% (up from a range of 10% to 14%) and its target for return on invested capital in real terms is now 15% (up from 12%). The previous targets were already quite ambitious and the new plan further highlights IAG's confidence.

See related report: IAG sets ambitious goals for 2016-20, including regular dividend, and declares its confidence

In the 12 months to 3Q2015, IAG's margin was 9.6% and its ROIC was 10.8%, according to its 3Q2015 results presentation. These results were short of its new targets, but the ROIC figure was ahead of its weighted average cost of capital, calculated by IAG to be around 10%, and its FY2015 performance should be better still.

In this respect - beating its cost of capital - IAG is already "showing the money". However, the real test of IAG's plan will be whether it can beat its cost of capital through the cycle, particularly in a downturn - something that no European legacy airline group has ever achieved.

IAG long term planning goals 2016-2020

Source: IAG Capital Markets Day presentation 6-Nov-2015

The group also plans for growth in earnings per share of more than 12% pa (up from 10% pa) and for average EBITDAR (earnings before interest, tax, depreciation, amortisation and rentals for operating leases) of around EUR5.6 billion pa (up from EUR5 billion). This EBITDAR target compares with EUR3.1 billion achieved in 2014 and EUR4.2 billion expected in 2015.

All of IAG's operating companies have the same 15% ROIC target as the group, but Iberia and Aer Lingus have slightly different targets from the group on lease-adjusted operating margin.

The only airline currently meeting targets for both measures is the LCC subsidiary Vueling. In the 12 months to 3Q2015, its margin was 12.6% and its ROIC was 13.6%. BA came close, with a margin of 11.0% and ROIC of 11.4%, while Iberia's margin was 5.9% (it has a slightly lower target range of 8% to 14%) and its ROIC was 7.5%. Aer Lingus achieved a lease-adjusted operating margin of 10.9% in the 12 months to 3Q2015 (its target is more than 10%), but its ROIC was 7.7%.

Non-fuel unit cost to fall every year 2016-2020

The increase in IAG's margin target demonstrates its increased confidence in its ability to improve its cost efficiency. Only part of this comes from lower fuel prices. IAG expects further reductions in the average fuel prices paid, since its hedges into 2016 are at lower prices than in 2015, a EUR2 billion benefit over the next three years.

However, its plan assumes that downward pressure on unit revenue will allow it to retain only 15% to 20% of this benefit in profit impact (slightly more for BA and less for Iberia). IAG expects non-fuel unit cost to fall every year through the plan, with labour productivity improvements playing an important part in this.

See related reports:

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Capital efficiency helps IAG to "show the money"

Although IAG does not set explicit targets for asset turn, its target for ROIC has been increased more rapidly than its margin target, and this also demonstrates the impact of capital efficiency. This measure is less visible than margin improvement, but capital efficiency is also a vital tool in driving up ROIC towards, and above, the cost of capital.

Being able to beat its cost of capital has given IAG the confidence to pay its shareholders a first-ever dividend payment this year. It plans to pay 25% of its underlying FY2015 profit after tax as a dividend to shareholders. Based on its forecast FY2015 earnings per share of EUR0.72, this would amount to EUR0.18 per share. Its board has already approved a down payment in the form of an interim dividend of EUR0.10 per share.

Further, the IAG share price has increased by 50% in the year between its capital markets days in 2014 and 2015, while Air France-KLM and Lufthansa shares have barely moved.

Whether judging the consortium by ROIC, dividend payment, or share price appreciation, shareholders of IAG will mark 2015 as the year in which IAG started to "show them the money".