14-May-2013 6:09 PM

IAG profit guidance is dropped after first quarter loss, but can it still reach its previous target?

Analysis

These are challenging times for IAG. The only one of the European Big Three to report a wider operating loss for 1Q2013 and to see net debt increase year-on-year, it also took significant new labour restructuring provisions in connection with Iberia. It has also dropped its previous ambitious target of exceeding 2011's EUR485 million operating profit in 2013 for the time being.

The first quarter operating loss was affected by two factors whose negative impact should fall away over the rest of the year: first, the lag between Iberia's capacity cuts and headcount cuts and, second, by a mirror image factor at British Airways, namely headcount increases ahead of the introduction of the A380 and 787 later this year.

Nevertheless, five years after the global financial crisis and more than two years into the British Airways/Iberia merger, IAG will need to show it can still match its previous 2013 profit target if it is to allay growing doubts over its ability to reach its 2015 goal of EUR1.6 billion in operating profit.

Summary

IAG reported a wider operating loss for 1Q2013 and saw net debt increase year-on-year.
The operating loss was affected by Iberia's capacity cuts and headcount cuts, as well as headcount increases at British Airways.
IAG dropped its previous target of exceeding 2011's operating profit in 2013.
Revenues were slightly up, driven by passenger revenues, while cargo revenues and other revenues declined.
Passenger unit revenue showed a positive trend, with growth in Europe, North America, and the Middle East, Africa & South Asia.
IAG took additional labour restructuring provisions and expects a substantial reduction in Iberia's operating loss in 2013.

IAG's 1Q2013 loss widens on currency impacts and restructuring

In 1Q2013 IAG's operating loss before exceptional items widened to EUR278 million from EUR249 million a year earlier. Its 1Q operating margin of -7.1% puts it between Air France-KLM (-9.3%) and Lufthansa (-5.4%), but IAG was the only one of the Big Three to see a fall in the margin. It was adversely affected by EUR67 million in relation to currency movements, which hit both revenues and costs negatively. The net loss widened to EUR630 million from EUR129 million after EUR311 million of restructuring provisions.

Revenues were just above flat on last year, up 0.5% to EUR3,939 million, on a capacity (ASK) decrease 2.1%; of which 0.6% was caused by the impact of 10 days of strike at Iberia, with an estimated cost of EUR29 million. Net debt fell from 31-Dec-2013 by 8% to EUR1.7 billion, but grew by more than 50% from a year earlier (the only one of the Big Three to see net debt grow year-on-year).

Passenger load factor gained 1.3ppts to reach 77.4%. Cargo traffic, measured in cargo tonne kilometres, fell by 8%. Looking at the two operating companies, Iberia capacity fell by 15.2%, while BA's grew by 1.7%. Iberia's pre-exceptional operating loss widened from EUR170 million to EUR202 million, while BA narrowed its loss slightly from GBP62 million to GBP58 million (including a GBP35 million negative impact from bmi).

IAG 1Q2013 financial summary

IAG 1Q2013 operating summary

Revenue growth driven by passenger business and positive unit revenue trend

Revenue growth of only 0.5% was driven by growth in passenger revenues of 1.7%, offset by a fall in cargo revenues of 7.2% and a 4.4% decline in other revenues. Revenues were negatively affected by EUR46 million of adverse currency movements.

IAG revenues 1Q2013

EUR million	1Q2012	1Q2013	Change	% of 1Q2013 total
Passenger revenue	3,290	3,346	1.7%	84.9%
Cargo revenue	291	270	-7.2%	6.9%
Other revenue	338	323	-4.4%	8.2%
Total revenue	3,919	3,939	0.5%	100.0%

Passenger unit revenue was up 3.9% year-on-year in the quarter; this would have been 5.3% on a constant currency exchange rate basis. Looking at rolling 12 month unit revenues at constant currency, there has been an upward trend since 3Q2012 and IAG says it sees no sign that this trend will change.

This trend holds for both the passenger and the cargo business and reflects better matching of supply to demand by IAG and by competitors in the market place.

IAG rolling 12 month unit revenue development passenger and cargo

Unit revenues are strongest in North America and Europe, weak in Asia-Pacific and domestic markets

Passenger unit revenue performance varied by region in the quarter, with strength in Europe (ex domestic), North America and Middle East, Africa & South Asia. Latin America saw flat unit revenues, while Asia-Pacific and the two domestic markets saw falls. This domestic weakness reflects poor demand in Spain and was also affected by the integration of bmi in the UK (which also boosted capacity growth). Latin America was hit by the Iberia strikes.

Asia-Pacific unit revenue weakness, also reported by Lufthansa and Air France-KLM, was caused by the weak yen and new routes (in particular Seoul). IAG CEO Willie Walsh told analysts on a conference call to discuss the quarterly results that IAG is, "different from Lufthansa and Air France-KLM. The yen hits everyone, but they are more affected by the Middle East carriers than us as we have more point-to-point traffic and they have more hub connecting traffic".

Regarding the ending of British Airways' joint business agreement with Qantas on the 'kangaroo route' to Australia, Mr Walsh said there was no impact on BA. "Australia is a small market", he said, adding that the benefits from BA's change to the 777-300 on the route and the integration of its Australian operations into Terminal 5 at Heathrow outweighed any disadvantage from the loss of the Qantas agreement. He also sees it as an opportunity for BA to address the Australian market outside Sydney with other partners.

The strength of unit revenue to North America reflects capacity discipline in the market, where the group cut capacity by 4% year-on-year. Mr Walsh does not see any need to adjust capacity upwards and argues that capacity discipline by all players has been a positive feature of the market, leading to unit revenue improvements. "I don't see anybody doing anything silly - quite the opposite", he said, referring to the possibility of a competitor breaking ranks to chase market share gains, although he admitted IAG would defend strategic markets if necessary.

IAG ASK and RASK % change by region: 1Q2013

Non-premium RASK growth stronger than premium

Looking at passenger unit revenues and traffic (RPK) by cabin, premium unit revenues grew by 2.2% at constant currency while traffic volume fell slightly. This was adversely affected by the move of Easter from April last year to March this year and by the Iberia strikes.

Non-premium unit revenue grew by 8.0% at constant currency, with volume also slightly down.

IAG 1Q2013 unit revenue development by cabin (at constant currency)

IAG's short-haul non-premium unit revenue outlook is strengthening

IAG continues to see a stable outlook for long-haul premium unit revenues particularly in North America, while short-haul premium remains soft. The outlook for long-haul non-premium is stabilising, with some regional disparity, but trends are improving for short-haul non-premium, where IAG describes the outlook as stable to strong. The cargo unit revenue outlook remains weak.

IAG underlying unit revenue environment by product segment

Costs grow faster than revenues, but short-term issues will fade later this year

Operating costs before exceptional items for the quarter were up 1.2%, faster than revenue growth, to EUR4,217 million. Costs were negatively affected by EUR21 million of adverse currency movements. Fuel costs fell 3.4% to EUR1,361 million.

Unit costs grew by 3.3% year-on-year in 1Q2013 (2.8% at constant currency). In a departure from the trend of many quarters, fuel unit costs fell by 1.5% (-1.1% at constant currency) so that ex fuel unit costs grew faster than the total, at 5.8% (4.9% at constant currency). Although rising unit costs are a worrying trend, they were negatively impacted by two short term issues: Iberia's labour cost reduction has lagged the capacity cut and BA has increased its headcount in advance of the introduction of new aircraft types (A380 and 787), which will be later than originally planned.

The impact of these factors should turn more positive later in the year. There was also some cost related to promotional activity for the Avios loyalty scheme and BA Holidays.

IAG unit cost development: 1Q2013

Additional restructuring provisions - towards labour cost saving by 2015 of around EUR360 million

Additional labour restructuring provisions of EUR265 million were taken in the quarter, bringing the total labour restructuring provision to EUR467 million. This followed the Iberia mediation agreement of 13-Mar-2013, which allowed for headcount reduction of 3,300, or 17% of the baseline 2012 Iberia workforce, and an average salary cut of 11% initially (7% ground and 14% flight crews). The agreement provided for an additional 4% salary cut if April productivity talks failed and this was subsequently imposed.

The headcount reduction has begun, with 1,400 people exited as of end of May and 80% of total redundancies by the end of 2013. IAG expects to achieve a gross labour cost saving by 2015 of around EUR360 million.

IAG anticipates that Iberia will see a "substantial reduction" in its operating loss in 2013 versus 2012, and to halt cash burn from 2H2013, as a result of labour cost savings (it expects a unit labour cost reduction of around 3% for Iberia this year) and lower fuel costs. The group also says that cost savings will have to be augmented by unit revenue improvements to achieve Iberia's "Transformation Spain" operating result turnaround plan of EUR450 million between 2012 and 2015.

There were also restructuring costs of EUR47 million in the quarter, associated with the return of leased aircraft and standing down owned aircraft.

FY2013 outlook contains no profit guidance

At its FY2012 results announcement in Feb-2013, IAG set a bullish target to exceed 2011's EUR485 million operating profit in 2013 (versus a EUR23 million loss in 2012. IAG has now decided not to give profit guidance for FY2013 due to the requirement for the group to seek shareholder approval for recently announced BA fleet replacement orders and the consequent requirement to report on any outstanding profit forecast as part of that process.

These orders consist of 18 Airbus A350-1000 aircraft for delivery from 2018 and 18 Boeing 787s (conversion of existing options) for delivery from 2017. These 36 firm orders are for the replacement of 30 of BA's 747-400s between 2017 and 2023 (it will have 37 747s by 2017, down from 52 at end 2012). Further options can be used to replace more aircraft or for growth. IAG says it has secured commercial terms and delivery slots for Iberia for A350s and/or 787s, which will only be converted into firm orders "when Iberia is in a position to grow profitably, having restructured and reduced its cost base".

The date for the shareholder meeting to approve the aircraft orders has not yet been set, but it is expected for some time in Sep-2013. In the meantime, IAG has provided the following statement on the outlook: "Current trading is in line with our expectations. For 2013, excluding Vueling, we expect to reduce Group capacity by 1.8%, and keep non-fuel unit cost flat versus last year."

The 1.8% capacity cut is focused on Iberia, which will cut capacity by 14%, while BA will grow by 2.8%. The group capacity cut will be 3.0% in 2Q2013 and 2.8% in 3Q2013, with 4Q2013 seeing an increase of 0.7% driven by BA's new A380 aircraft. The group's target of flat non-fuel unit costs implies a reduction over the rest of the year, since the first quarter saw growth of 5.8%. IAG estimates a fall in its FY2013 fuel bill to EUR5.8 billion from EUR6.1 billion in 2012.

IAG capacity growth plan: 2013

Vueling to be consolidated from May-2013, but will remain a standalone operation

IAG increased its holding in Vueling to 90.5% on 23-Apr-2013, from the 45.6% it already owned, for a cash cost of EUR123.5 million. Vueling will be consolidated into IAG Group accounts from May-2013.

Mr Walsh reiterated previous comments that Vueling will be run as a stand-alone business within the group. There is potential for some synergies and a joint ground handling contract has already been tendered at Paris Orly, for example, but this was not a factor in taking the decision to buy Vueling.

IAG Group structure post Vueling acquisition

A new CEO for Iberia

Since 27-Mar-2013, Iberia has had a new CEO, Luis Gallego, who was previously the founding CEO of Iberia Express (2012 to 2013). A graduate in Aeronautical Engineering of the Technical University of Madrid and of IESE Business School, he spent nine years at Air Nostrum before moving to the start-up Clickair as COO in 2006.

He joined Vueling in 2009 upon its merger with Clickair (PDD). Mr Gallego's first task as Iberia CEO has been to implement the mediator's labour proposals, but Mr Walsh expects him to bring greater commercial discipline to Iberia, with a focus on profitable routes and not just market share.

New Iberia CEO Luis Gallego

IAG's previous profit target may still be possible

IAG's limited guidance for FY2013 no longer provides profit guidance, but what it has said still allows the possibility that it can achieve its previously announced (and ambitious) target of exceeding 2011's EUR485 million operating profit in 2013. It says that capacity will be down by 1.8%, a little less than the 2.1% cut in 1Q2013 when revenues grew by 0.5%. It has not given guidance on unit revenues, but has said that it expects positive unit revenue trends to continue. Making the fairly conservative assumption that total revenue growth for the year is 0.5%, the same as in the first quarter would add around EUR90 million to FY2012 revenues in FY2013.

On costs, IAG says that it expects non-fuel unit costs to be flat year-on-year and that it expects the total fuel bill to be EUR5.8 billion (down from EUR6.1 billion in 2012). If non-fuel unit costs are flat, this implies that, in absolute terms, they fall by 1.8% (the same as the capacity cut), giving cost savings of around EUR200 million versus last year.

Taken with IAG's expected EUR300 million reduction in the fuel bill, its guidance could add up to a total operating profit improvement of EUR590 million, enough to take it from last year's EUR23 million loss to more than 2011's EUR485 million operating profit in 2013.

This remains subject to many things going well for IAG, including completing the Iberia restructuring programme, capacity discipline continuing to hold in the market and having no other one-off disruptions, but it is not unlikely that it remains IAG's target, even if it cannot say so.