Initiating IAG Coverage: Undervalued Stocks

Total revenue per available seat kilometer increased from €8.93 cents in 2019 to €10.68 cents in 2023.

Morningstar Key Values ​​for IAG

• Estimated fair value: GBX 224
• Morningstar rating: ★★★★
• Economic moat: None
• Morningstar Uncertainty Rating: High

This growth was driven by strong travel demand, with RPK growth outstripping available seats (ASK) due to limited aircraft supply and airlines’ ability to pass on cost increases to customers. We expect IAG’s outlook to remain positive over the medium term, with RPKs expected to reach 125% of 2019 to 2028 levels. However, the industry will face economic challenges due to continued supply chain and spending issues increased operating costs, especially labor costs and interest rates for debt service. We anticipate that IAG’s revenues will gradually decline to pre-Covid levels by 2028 due to increased competition, which will put pressure on fares as aircraft and crew shortages ease. We project ASK to grow at a CAGR of 5% over our forecast period, compared to RPK growth at a CAGR of 4.9%.

In 2023, IAG’s revenue per passenger kilometer reached 95.7% of 2019 levels, and we expect it to exceed 2019 levels in 2024, growing at a CAGR of 5.4% through 2028. This growth is driven by strategic investments in the modernization of the fleet, increasing the degree of use of aircraft. , and a focused expansion in key profitable markets such as the North Atlantic and Latin America.

The company is optimizing its cost structure through a transformation program that includes investing in more fuel-efficient aircraft and increasing the predictability and stability of labor costs through multi-year union agreements. Over the next five years, IAG plans to replace 140 aircraft with new models that are 20%-40% more fuel efficient. The updated fleet should also lead to lower training and maintenance costs. We expect IAG’s outlook to remain positive over the medium term, with RPKs expected to reach 125% of 2019 to 2028 levels.

Fair value and profit generators

We assign an estimated fair value of GBX 224 per share to IAG, supported by robust travel demand, gradual capacity recovery and improved operational efficiency leading to improved profitability and cash flow generation.

In the wake of the pandemic, European airlines, including IAG, achieved record passenger revenues. In 2023, IAG’s revenue yield per passenger-kilometer collected reached EUR 9.36 cents, up from EUR 7.86 cents in 2019. Total revenue per available seat-kilometer increased from EUR 8.93 cents in 2019 to 10.68 euro cents. This increase was driven by 23 cents. travel demand, with RPK growth outpacing ASK due to limited aircraft supply and airlines’ ability to pass on cost increases to customers. We believe revenues will gradually decline to pre-covid levels by 2028 due to increased competition, which will put pressure on fares as aircraft and crew shortages ease.

We project ASK to grow at a CAGR of 5% over our forecast period, compared to RPK growth at a CAGR of 4.9%.

IAG’s Economic Moat

We don’t think International Airlines Group has an economic moat. IAG operates as a European network operator with major hubs in London Heathrow, London Gatwick, Madrid, Barcelona and Dublin. Network carriers funnel passenger traffic through expensive, slot-constrained airport hubs, handling numerous connecting passengers. This model requires a complex and varied fleet with multiple aircraft types and cabin configurations to address different route lengths, traffic patterns and customer requirements.

Scheduling complexity and the need to accommodate connecting passengers often result in lower fleet utilization and lower load factors compared to low-cost carriers. To offset higher unit costs, network airlines aim to generate higher unit revenue by offering a wide range of fare classes, including business and first class, and through codeshare partnerships with other airlines and passenger programs frequently to attract and retain passengers. Although IAG achieved a return on invested capital above its cost of capital from 2015 to 2019, we believe this is unsustainable. In the long term, IAG is likely to face the same economic pressures that plague the wider airline industry, hampering its ability to maintain consistently high profits. The competitive dynamics of the airline industry present significant challenges for any company aiming to achieve long-term economic returns.

Financial strength of IAG

IAG entered the covid-19 pandemic with relatively lower debt levels than peers and by 2023 had reduced its net debt by more than £3bn from its peak in 2021. The company has repaid a significant from variable debt, including 2 billion euros. UKEF-backed debt for British Airways and €800m of ICO debt for Iberia, reducing its exposure to floating interest rates and financial volatility. Currently, 83% of gross debt is related to aircraft financing, and the remaining debt, which is not related to leasing, is spread over the next six years, with most of it maturing starting in 2026. In addition, the pension fund of IAG for British Airways is now in technical surplus, eliminating the need for additional contributions in the short term.

In the first half of 2024, the group had net debt of £6.4bn and total liquidity of around £13.2bn, made up of £9bn in cash and £4bn in facilities. This strong liquidity ensures that the company can effectively manage its debt obligations spread over the next six years. IAG targets a net debt/EBITDA ratio of less than 1.8 times over economic cycles. This ratio is currently well below the target of 1.1x, down from 1.8x at the end of 2023, demonstrating the company’s prudent financial management.

Allocation of capital

We assign IAG a standard capital allocation rating based on a strong balance sheet rating, a fair shareholder distribution rating and a fair investment rating. IAG is committed to delivering shareholder returns. From 2013 to 2019, the group returned approximately EUR 4.3 billion in excess capital to shareholders through share buybacks and dividends, while maintaining a prudent capital structure. Beginning in the second quarter of 2024, the company reinstated dividend payments, with an interim payment of $0.03 per share.

The Group is dedicated to improving cost efficiency and maximizing return on invested capital, which has historically resulted in margins and ROICs that significantly exceed those of its competitors, with the company delivering ROICs higher than its cost of capital from 2015 to in 2019. We expect the company to continue to invest in initiatives that drive cost savings and fleet optimization. For example, the company is currently engaged in an ongoing transformation program that is expected to further improve margins by optimizing fleet utilization, minimizing maintenance costs and leveraging economies of scale across the group. By centralizing maintenance operations across the various airlines, IAG ensures a more efficient use of resources and maintains a consistent quality of service through common facilities and standardized procedures.

The bulls say

• The group’s higher margins and lower debt levels give it more flexibility than peers to weather the current recession.
• Investments in fleet rationalization will result in a less complex, more flexible and efficient asset base.
• Using a high share of leased aircraft in its fleet gives the group greater flexibility in managing capacity during an uncertain demand environment.

The bears say

• The group’s high exposure to high-margin business travel may result in pressure on margins if business-related travel remains persistently below pre-Covid-19 levels.
• Amid very strong demand and tight capacity, IAG may face challenges in supplying its premium cabin.
• European low-cost airlines with aggressive growth ambitions and better cost structures could seize the opportunity to take part in the group’s most profitable intra-European short-haul routes.