With the forced exit of Photo Me International from the portfolio a space has opened up in the industrial category. I have had my eye on several – there are a few decent companies but many are overpriced at this stage in time. However, I feel that doesn’t apply to International Airlines Group (IAG), the parent owner of airlines British Airways, Iberia and Aer Lingus, so I have decided to add this to the portfolio as of yesterday.
The investment case could said to be a little bit too late, as we can see from the share chart:
As we are coming in at (almost) a 52-week high – had this purchase been only a month earlier we would have been already sitting on a decent profit. However, the price has jumped since May on the first quarter results, and with the following periods looking promising, there could be better news to come.
On other grounds, the investment case stacks up. On a pure price to earnings ratio, IAG must be the cheapest large-cap out there – until the recent jump in price, it was trading at a ratio of under 7 – by contrast Easyjet and Wizzair trade at double this at 14. I believe these are slightly too high for the LCCs (I owned Easyjet last year when it was trading at 940p – good value then) and although they are simpler products, a parent group such as IAG owns a better diversified range of products.
The valuations speak for themselves, Easyjet are worth almost £7bn at todays prices, IAG £14bn. But since ironing out their problems, IAG have become extremely profitable, putting out profits four times greater. Growth for them appears to be much more feasible, as they fly all over the world, or alternatively they could simply acquire another airline to put into the group. By contrast, Easyjet’s focus is Europe, an extremely mature market where Ryanair offer formidable competition.
Perhaps it is my job to pick out the negatives and ask: why is IAG so undervalued by the market? I can think of a couple of reasons why investors may be nervous.
The first is Norwegian – one of the few low budget, long-haul carriers. They have expanded rapidly and flying out of big airports such as Gatwick and Barcelona, they have started undercutting IAG massively on long-haul routes. The strategic response has been varied: first IAG opened their own low-cost long haul airline (LEVEL), British Airways have started duplicating routes to marginal locations such as Oakland, and more recently have started attempting to simply purchase Norwegian.
One of the problems here is that the purchase price of Norwegian may be large – certainly above today’s market cap of £1.5bn, for operations that many in the industry regard as unfeasible in the long-run. The purchase simply remove a competitor, and allow IAG a nice source of new airframes, and some landing slots. Arguably the numbers could stack up for IAG but transitional costs may be very high.
Another is that aviation markets change rapidly. Capex requirements are high as new aircraft are needed as older ones come to the end of their life. Many sources of competitive advantage – for instance, airline dominance of their home airport exist because of governments and whilst this is not likely to change in the short-term, turning losses into profits is a slow affair due to costs being committed. Likewise, it is easy for the pendulum to swing in the other direction. A rapid loss of consumer confidence hits the less flexible airlines, who will have to continue to run flights for a pre-determined period.
Another particular area of concern is fuel costs. Airlines are very sensitive to this as it makes up a significant proportion of costs (around 20%). Whilst many use futures markets to hedge costs and provide certainty for upcoming periods, an increase in oil prices means that at some point, operating costs increase and if fares don’t increase, then profit falls.
One last specific problem may be BA’s pension scheme – which had a deficit of some £2.8bn at the last valuation. The defined benefit scheme has now closed but over the long run this shortfall may have to be made up if assets do not perform.
Having said this, I see a good future for IAG. Their brands are much maligned by many travellers (premium classes are not as good as competitors) but despite this it remains a hugely profitable airline. They have been very bullish about the future, and further good results should push the price towards an improved P/E rating.
The out here is simple: at around 580p the 15% loss will have arisen; this would be lower than it has been in a year. In the meantime there is a dividend yield of c.4% and a buyback program is underway.
Pure Passive Investor. Always looking for ways to make money (but not myself) work harder.