01-Mar-2013 5:00 PM

IAG slips into losses, targets immediate bounce-back. But further austerity will be needed all round

Analysis

Reversing the rising trend that began before the 2011 merger of British Airways and Iberia, IAG slipped back into losses in 2012. Quite simply, unit costs grew faster than unit revenues. Iberia's losses widened again and BA's profits declined. Labour productivity, a key factor in airline profitability, fell in 2012. This was partly due to the integration of bmi and also to capacity cuts at Iberia being implemented ahead of headcount reductions, but 2013 will need to see an improvement in this area.

In 2013, IAG plans a capacity cut of 1.9% with Iberia capacity down 10% to 15% and BA capacity up around 2%, fuelled by its first A380 deliveries. The Iberia capacity cuts, together with a planned workforce reduction of 3,800, are the subject of a bitter dispute with labour unions in Spain. Management's ability, or otherwise, to see its plans through will be a defining feature of the year ahead.

IAG's bullish target to exceed 2011's EUR485 million operating profit in 2013 will depend on this, regardless of whether or not Vueling fully joins the group this year.

Summary

IAG (International Airlines Group) slipped back into losses in 2012 due to unit costs growing faster than unit revenues.
Labour productivity fell in 2012, partly due to the integration of bmi and capacity cuts at Iberia.
IAG plans a capacity cut of 1.9% in 2013, with Iberia capacity down 10% to 15% and BA capacity up around 2%.
Iberia's losses widened in 2012, while BA's profits declined.
IAG's net debt has been on a rising path since 2010, reaching EUR1.9 billion at the end of 2012.
IAG aims to exceed its 2011 operating profit of EUR485 million in 2013, but this will depend on the successful implementation of its plans and the resolution of the dispute with labour unions in Spain.

Red ink returns in 2012 accounts

IAG slumped to a net loss of EUR885 million in 2012, after two years of positive results for the British Airways-Iberia combination. The net result suffered from a number of one-off items, including EUR202 million of provisions related to Iberia restructuring, EUR87 million of bmi restructuring, a EUR343 million impairment charge in connection with Iberia (lowering of value of Iberia recorded in IAG group accounts) and a EUR266 million non-cash pension-related charge.

The operating result better reflects underlying performance and this, too, fell into negative territory with a loss of EUR23 million, mainly resulting from a wider loss at Iberia, but also due to lower profits at BA.

Exchange rate effects resulted in a net adverse impact on operating loss of EUR107 million. The operating loss, however, was narrower than the EUR120 million that IAG had guided the financial markets to expect and better than the EUR88 million consensus forecast loss (source: Bloomberg).

IAG financial highlights (EUR million except where stated): 2012 vs 2011

	2011*	2012	*Change*
Revenue	16339	18117	10.9%
Operating result before exceptional items	485	-23	-104.7%
EBIT margin %	3.0	-0.1	-3.1ppts
Net profit	555	-885	-259.5%
Cash	3735	2909	-22.1%
Gross debt	4883	4798	-1.7%
Net debt (minus sign indicates net cash)	1148	1889	64.5%
Equity	5686	5055	-11.1%
ASK (millions)	213193	219172	2.8%
RPK (millions)	168617	176102	4.4%
CTK (millions)	6156	6080	-1.2%
Load factor %	79.1	80.3	+1.2ppts
Reported
Passenger RASK (c.€)	6.41	7.01	9.4%
CASK (c.€)	7.44	8.28	11.3%
CASK ex-fuel (c.€)	5.06	5.49	8.5%

Previous positive profit trend reversed

The merger of BA and Iberia, to form IAG, completed on 21-Jan-2011. The chart below shows the net profit and operating result that it would have reported if the merger had been in place for the full years 2009 to 2012. After heavy losses in 2009, the year of global economic contraction, results returned to profit in 2010 and 2011 driven by a rising sales trend.

The return to an operating loss in 2012, in spite of further sales growth, highlights the precarious nature of IAG's profitability.

IAG revenues, net profit and operating profit (EUR million): 2009* to 2012

Another loss for Iberia

Iberia has not achieved an operating profit throughout the period 2009 to 2012 and has been on a downward trend since 2010, the year before the merger.

BA has been profitable since 2010, but its fall in operating profit should not be ignored amid all the focus on Iberia.

IAG operating profit by business segment (EUR million): 2009*-2012

IAG's net debt is rising

IAG's net debt has been on a rising path since 2010 and its cash position has been declining. Its 2012 year end net debt of EUR1.9 billion would be EUR5.3 billion if operating leases, capitalised at eight times annual lease payments, were added. While IAG's financial gearing, or net debt (adjusted for operating leases) to equity ratio, of 106% is well within the range of competitor airlines and BA's historical levels, it is sharply up from 77% in 2011. IAG management will not want to see it increase further.

IAG development of net debt and cash: 2009*-2012

Modest capacity growth for the group, with cuts at Iberia

IAG increased its passenger capacity by 2.8% in 2012, with BA up 5.4% and Iberia down by 3.3%. Excluding the impact of the bmi acquisition, IAG's capacity growth was just 0.7% (lower than the originally planned 2.5%) and BA's like for like growth was 2.5%. BA and Iberia's combined passenger capacity has grown on average by a modest 2.0% p.a. since 2009 (all due to BA growth; Iberia has contracted), reflecting soft demand conditions and a focus on trying to improve cost efficiency rather than grab market share.

Partly as a result of this capacity caution, load factor has improved by 1.7ppts since 2009 (1.2ppts in 2012 alone).

IAG development capacity (ASK, million) and load factor (%): 2010*-2012

Strong RASK in 2012, assisted by currency impacts, drives revenue growth

IAG's revenues were up 10.9% in 2012, in spite of modest capacity growth, reflecting a 9.4% increase in passenger revenue per ASK. Exchange rate effects helped this RASK performance - it would have been up by 3.9% at constant exchange rates. British Airways' reported EUR revenue grew by 15.9%, while Iberia's fell by 1.1%. BA's GBP reported revenue grew by 8.4%, with GBP reported RASK up 2.9%.

In terms of region of sale, growth was strongest in the UK, Spain and the USA, at more than 17% in each of these countries. Given that Iberia saw an overall revenue decline, this growth in sales in Spain presumably reflects a strong performance by BA, most likely in bringing Spanish passengers to its London hub for onward connections.

IAG revenues (EUR million): 2011 and 2012

	2011	2012	*Change*	*% of 2012 revenue*
Passenger revenue	13,675	15,372	12.4%	83.7%
Cargo revenue	1,190	1,217	2.3%	7.3%
Other revenue	1,474	1,528	3.7%	9.0%
Total	16,339	18,117	10.9%	100.0%

British Airways	11,483	13,312	15.9%	70.3%
Iberia	4,856	4,805	-1.1%	29.7%
Total	16,339	18,117	10.9%	100.0%

IAG geographical breakdown of traffic revenues by area of sale (EUR million): 2010*-2012

	2011*	2012	*Change*	*% of 2012 revenue*
UK	5,124	6,029	17.7%	33.3%
Spain	2,168	2,548	17.5%	14.1%
USA	2,247	2,647	17.8%	14.6%
Rest of World	6,564	6,893	5.0%	38.0%
Total	16,103	18,117	12.5%	100.0%

Costs (+14.4%) grew faster than revenues (+10.9%) in 2012

IAG's operating costs grew by 14.4% in 2012, faster than the growth in revenues (10.9%) and much faster than the growth in capacity (2.8%). This largely reflects a 20% increase in fuel costs, which were more than one third of total costs in 2012. Labour costs, the second biggest item, grew by 12.2%, with average headcount up 4.9%.

IAG says this rapid rise in employee costs reflects adverse exchange rates, wage awards, increased volumes and employee provisions. The acquisition of bmi contributed to a lowering of productivity, as did capacity cuts at Iberia that took place prior to headcount reductions.

IAG operating costs (EUR million): 2011 and 2012

	2011*	2012	*Change*	*% of 2012 revenue*
Employee costs	3,870	4,341	12.2%	23.9%
Fuel	5,068	6,101	20.4%	33.6%
Handling, catering, other operating	1,545	1,805	16.8%	10.0%
Landing fees & en route charges	1,200	1,278	6.5%	7.0%
Engineering	1,099	1,285	16.9%	7.1%
Property, IT & other	918	997	8.6%	5.5%
Selling costs	756	830	9.8%	4.6%
Depreciation, impairment	979	1,071	9.4%	5.9%
Aircraft leases	403	432	7.2%	2.4%
Currency differences	16	-	-100.0%	0.0%
Total	15,854	18,140	14.4%	100.0%

IAG has hedged 60% of its 2013 jet fuel needs to give an average price of USD1,013/mt (average of hedged prices and unhedged prices using current levels). This leads to an estimated full year 2013 fuel bill of EUR6.0 billion (down slightly from 2012's EUR6.1 billion).

Reported unit costs (costs per ASK) increased by 11.3% and ex fuel unit costs grew by 8.5%, with all cost areas (in particular labour) contributing to this growth. Adverse currency movements also contributed - ex-fuel unit costs at constant exchange rates would have been up 3.8%. BA's GBP ex-fuel unit costs were up 4.3%.

IAG unit cost growth: 2012

	Reported	At constant currency
Fuel	16.8%	8.4%
Employee	8.8%	4.4%
Supplier	8.8%	3.8%
Ownership	6.2%	0.0%
All non-fuel	8.5%	3.8%
All costs	11.3%	5.2%

As noted above, labour productivity declined year on year and employee costs per ATK increased by 8.9%. IAG will have to demonstrate in 2013 that it is in control of this measure. Revenue per employee grew by 5.7%. IAG's labour productivity remains in the middle of the pack of European legacy carriers, as noted in our analysis 'European airlines' labour productivity', 15-Feb-2013. This disguises considerable differences between BA, which is among the better performing legacy flag carriers, and Iberia, which is among the worst.

CAPA has previously analysed both BA and Iberia's labour productivity separately from IAG, but the group has not yet published individual company accounts to allow the updating of this analysis beyond a look at IAG.

See related articles:

IAG labour productivity measures: 2011 and 2012

	2011	2012	Change
Total full time equivalent headcount	56,791	59,574	4.9%
Total labour cost EUR million	3870	4341	12.2%
Employee cost per employee (EUR)	68,145	72,867	6.9%
ATK per employee	529	520	-1.8%
Employee costs per ATK (EUR)	0.13	0.14	8.9%
Revenue per employee	287,704	304,109	5.7%

Modest capacity cuts are planned for 2013, deeper in summer

IAG is planning a 1.9% cut in capacity (ASKs) in 2013, with the summer season seeing deeper cuts of more than 3%. The group plans ASK growth of around 2% for BA and a 10% to 15% cut for Iberia in 2013. Much of BA's growth will result from bringing three A380s into its fleet, with the first due in July. BA expects to announce its first A380 route in the next couple of weeks (Hong Kong, Singapore, New York are the favourites).

BA is also due to take delivery of the 787 from May this year, but the timetable is now likely to slip. Speaking at the 2012 results presentation, IAG CEO Willie Walsh said that he does not see this as a major problem, as BA would continue with its 767s. He remains confident that Boeing will resolve the problems faced by the 787, adding that he regards it as a "fantastic aeroplane".

Mr Walsh told the 2012 results meeting that "Iberia will only grow when Iberia can grow profitably". The Iberia transformation plan, in addition to capacity cuts, proposes headcount reductions and is currently in consultation until 12-Mar-2013 with employee groups, who have indicated their opinion by calling strike action.

IAG planned capacity (ASK) changes by quarter 2013

Unit revenue outlook mainly stable for passenger business, weak for cargo

The company says that the outlook for unit revenues is stable for premium cabins, although competitive in short haul premium. In non-premium it sees soft unit revenues on short-haul, while long-haul unit revenues are stabilising. Cargo unit revenues continue to be weak, with overcapacity still evident. Mr Walsh said that there were some signs that the cargo decline might be bottoming out, especially in Asia.

IAG's unit revenue environment

IAG's Group target is to beat 2011 operating profit in 2013

Other than its capacity plans, IAG is refraining from giving any forecasts for 2013, pointing out that the outcome of the Iberia transformation plan negotiations, and any associated costs and losses, will be critical. Nevertheless, subject to these caveats, the company expects a better pre-exceptional operating result than in 2011, when it recorded EUR485 million.

This looks like an ambitious target, although it is still small in terms of margins. In 2011, this operating profit represented a 3.0% margin, but after revenue growth of nearly 11% in 2012 and assuming little or no revenue growth in 2013, this would represent a margin of only around 2.5% if achieved.

IAG's offer for Vueling proceeds, but will IAG increase the price?

IAG is proceeding with its EUR7 per share offer for the 54% of Vueling that it does not already own. At the 2012 results presentation, Mr Walsh observed that Vueling has a good track record, a very good management team and a great cost base, commenting also that the real opportunity in acquiring Vueling would be to allow it to develop as it has done as a stand-alone entity.

This makes sense, given the different cultures and strategic approaches of the two companies, at least in the near to medium term. No doubt, if the acquisition is successful, IAG would consider closer integration over the longer term.

CFO Enrique Dupuy said that the tender process allowed for a different price to be negotiated with the Vueling board if it did not feel that it could recommend the offer to shareholders. Given that Vueling shares have been trading close to EUR8, and Mr Walsh's positive comments about Vueling, a revised (higher) offer price looks likely. The deal is expected to complete some time in April, if accepted by Vueling shareholders.

See related article: Vueling: a Spanish success story coveted by IAG

RASK has been strong with capacity discipline, but CASK is also on the increase

As with many European airlines, IAG's unit revenues (RASK) have been on an upward curve in recent years as a result of capacity discipline better matching supply to demand than in previous times of economic weakness. IAG's own modest capacity growth, in addition to its premium branding and BA's strength at the capacity-constrained and high-yield Heathrow, has contributed to its strong RASK performance, but ultimately RASK is unreliable and can fall dramatically when conditions outside management control weaken.

Consequently, management will need to concentrate on costs and IAG/BA/Iberia have made a fair stab at controlling ex-fuel unit costs - although the increase in 2012 means that they are almost 10% higher than in 2009.

Of course, the focus on ex-fuel unit costs does not avoid the need to pay for fuel and IAG's overall unit costs are 19% higher than in 2009. Even with RASK growth, profits deteriorated in 2012 as CASK grew more quickly. This further emphasises the imperative to reduce CASK in anticipation of any conditions that might lead to a fall in RASK.

IAG - index of operating cost per ASK and fare revenues per ASK (each indexed to 100 in 2010)

The focus is on Iberia, but IAG should not forget about BA

As demonstrated by Iberia's ongoing losses and its poor labour productivity, IAG is right to concentrate on the Iberia transformation plan in order to restore group profitability. Nevertheless, the fall in profit at BA should also be a warning, especially given that its ex-fuel unit costs, as reported in its domestic GBP currency, increased by 4.3% in 2012. BA has lower unit costs than Iberia, but it also has a longer average sector length.

Comparing CASK and average sector length for BA and Iberia with other major European carriers, both are close to the trend line for the big flag carrier groups, which are all much higher cost than the LCCs. Recent moves at BA, such as offering hand-luggage only tickets to five destinations from Gatwick at discounted prices, suggest that IAG continues to look at ways to make BA more competitive. Moreover, Mr Walsh has already implemented some restructuring and new working practices at BA; but the UK arm of IAG is not flying through clear skies.

The addition of Vueling to the group would be welcome, but would not avoid the need to continue to attack costs at both of IAG's flag carrier airlines. According to Mr Walsh, the performance of Iberia Express has been "stunning" operationally and it was profitable from its third month after launch at the end of Mar-2012.

However, he continues to balance the need to increase the use of this lower cost subsidiary with avoiding further aggravating labour unions and this will be an ongoing challenge in the current industrial relations environment.

IAG will not be alone in hoping the effects of the recent Italian election result do not fuel further toxic austerity disenchantment across Europe.

Unit costs (cost per available seat kilometre) and average stage length for selected European legacy and low-cost carriers: 2011, 2012*