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IAG | Investment Analysis

The airline sector is among the most affected by the recent global pandemic. Strict lockdown measures curbing global travel has led to several airlines grounding entire fleets and furloughing thousands of employees, bringing the industry to its knees. While this resulted in a significant market sell-off, fear and not facts have been the key driver of current market prices. Airlines with strong liquidity are now trading at lower earnings multiples to airlines at the brink of bankruptcy. Investors must be willing to overcome their emotions and rely on objective financial analysis to benefit from the opportunities present in the current market, waiting to be exploited by those willing to scrutinise.

Now to get to my top pick for both, in providing the most value and margin of safety at current prices is: IAG.


International Consolidated Airlines Group, S.A.


IAG, or International Consolidated Airlines Group, S.A., the owner of British Airways, Iberia, Aer Lingus and Vueling, is one of the largest European airline operators in the world. They hold a fleet spanning ~600 aircraft (~200 wholly-owned) and market-leading positions across Europe. Iberia and Vueling alone, hold 58% market share of passenger seats in Spain, potentially increasing to 73% with the Air Europa acquisition. Revenues are well-diversified - 60% derived from British Airways, Spanish airlines Iberia & Vueling contributing 30% and 10% from Irish flag-carrier Aer Lingus and other airlines in the portfolio.

The company’s balance sheet is among the best in the industry. Liquidity, as at 27 March 2020, was €9.3billion (€7.2billion in cash & equivalents and €2.1billion in undrawn credit facilities), based on recent company filings. They further outright own ~200 aircraft held at NBV of €5.3billion. On the other side, IAG has estimated yearly fixed costs of €4billion, lease obligations of €2billion and no principal repayments of borrowings until 2022. Other smaller liabilities amount to about €200million. With a liquidity position of €9.3billion, IAG can pay their obligations totalling €6.2billion for the 12-months ahead without the need to earn any revenues and still having €3.1billion in liquidity. A massive €3.6billion liability for deferred revenue on ticket sales, bears heavy on the balance sheet. Regardless, it suffices to say IAG has the liquidity and €5billion worth of owned aircraft to raise additional capital where necessary, to weather further costs and liabilities.

Ryan Air, upon a similar analysis, holds a potentially healthier balance sheet. €4billion in liquidity enough to offset fixed costs (~€1billion), loans & lease maturities (~€350million) and potential deferred revenues (~€2billion). For additional capital requirements, they have access to a fleet consisting of 300 owned aircraft valued between €8-10billion, enough to almost settle their liabilities twice over.


The Market Environment


A dive into the industry, and many unpromising events are found. Flybe, the largest independent regional airline in Europe, collapsed in early March. Easy Jet, one of Europe’s top 3 largest low-cost carriers, yesterday reported raising £2billion over the past few weeks, walking away 250% more levered a few weeks into the crisis. Virgin Atlantic saw its 30% stake in Flybe reduce to zero and signalled significant risk of collapsing in the absence of government intervention. Norwegian Air, among the most levered airlines with little cash relative to liabilities, is weeks away before flying to its demise.

Lufthansa, Germany’s flag-carrier and largest airlines, in mid-March, announced raising €600million to increase liquidity to €4.3billion, just about enough to cover fixed costs. While the company does have much room to leverage their balance sheet, this will likely be a near-term occurrence at a great expense to shareholder equity. Air France, one of Europe’s largest airlines, also lacks much liquidity and is in talks of help from the French government. Among the major airlines, IAG and Ryan Air are the two airlines not to have requested government aid and have sufficient liquidity on hand.


Valuations


In the meantime, here is IAG trading at 2 times trailing earnings despite having enough liquidity to survive months on end without any revenues. Ryan Air trades at about 11 times trailing earnings and commands a solid balance sheet; however, at current prices, an adequate margin of safety cannot be found. They are likely to have to leverage their balance sheet further and suffer losses in the near-term, which is not correctly priced into the current relatively optimistic share price.

Air France-KLM, similarly, trades higher to IAG at 8 times earnings despite having much weaker liquidity and a mere net profit margin of 1% compared to IAG’s 9.5%. Air France has a lot of owned aircraft on its balance sheet. However, Investors at this valuation are overpricing the shares and neglecting the impact of leverage and the risk of share dilution, as an equity issue to raise further capital seems probable.

Norwegian Air doesn’t pose much for comparison, except that it is currently hard at work destroying shareholder equity, issuing shares at nonsense prices and continuously raising more debt, all just to stay afloat in the short term. They are severely loss-making, and regardless of a bail-out from the Norwegian government, are not worth further consideration, except for maybe by the speculator.

Lufthansa, the German leader, currently trades at 3 times trailing earnings. While more reasonable to Air France, they still stand inferior to IAG on many metrics, with the major being the uncertainty of the extent to which they will need to lever their balance sheet. They also have lower growth prospects, are about 3 times less profitable and have had to cease Germanwings, a subsidiary airline permanently. I see no reason as to why I’d pay a premium for Lufthansa, when I can buy IAG, a far better company overall, at a lower valuation.


The really ridiculous valuation found is of Easy Jet, trading at 7 times trailing earnings. The company reported yesterday an anticipated cash burn of £3billion over 9 months, in a no flights scenario. This amounts to just under their entire current liquidity of £3.3billion, which has been bolstered by a massive £2billion debt issue, almost the same size as its current market capitalisation. The impact of this debt has been severely underestimated and not been correctly factored into the share price. The cash raised will be used to remain liquid, not build an asset base, thereby directly destroying residual shareholder interest on assets from 50% to about 20%. A further £1billion debt issue can see residual shareholder interest being wiped out. It’s absolutely absurd, the markets willingness to pay 3-4 times more for Easy Jet’s future profits, a company with a weaker balance sheet, lower revenue diversification and in dire need of liquidity, can’t surely be more promising than IAG?


Sector


As a whole, the airline sector is in better shape than most think, especially the larger airlines such as IAG, Ryan Air, Lufthansa and Air France. These are well-run companies with a high percentage ownership of aircraft on their balance sheet, thereby creating much room to leverage up and survive the storm. Investors should be mindful, and carefully factor in the effects of debt in the share price and avoid paying too much. While revenues and profitability will dry up over the next year or two, the industry will return to or exceed the profitability it enjoyed pre-crisis, achieved from decades of consolidation and cost-efficiency. The airlines most at risk of failure are the smaller, poorly run airlines who operate at margin and will likely run out of cash very quickly.

The European airline industry continues to remain very fragmented and in desperate need of further consolidation to promote higher stability and profitability, similar to that of in the US airline industry. While the current crisis may not accelerate consolidation, it will, however, remove the poorly managed and highly levered airlines, allowing the bigger, better-managed airlines to fill the gap. IAG and Ryan Air, will be among the biggest beneficiaries from such an outcome.


Overall, the best investment value at current prices can be found in IAG. The profoundly negative sentiment for the company and industry is evident in its share price. At 2 times earnings, a solid balance sheet and a portfolio of quality brands, the airline provides superior value and an adequate margin of safety for the long-term investor.




Disclaimer: The report above is strictly for information purposes only, and does not constitute professional advice or a recommendation to purchase or sell any securities. We do not endorse the use of the report above, for use as a basis for any investment decision.

© 2020 Westrow Capital Management, LP

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