Financial Analysis of International Airlines

Financial Analysis of International Airlines Group

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Today, the aviation industry is faced with skyrocketing energy costs, the lingering aftereffects of the Great Recession of 2008 and the looming threat of ongoing terrorist activities in many regions of the world. In this environment, identifying opportunities for air carriers to achieve a competitive advantage through improved administrative and operational practices represents a timely and valuable enterprise. Therefore, the purpose of this study was to provide a review of the relevant peer-reviewed, scholarly and industry literature concerning these issues and to calculate and benchmark relevant financial analyses of International Airlines Group (IAG) compared to three of its competitors, Turkish Airlines, Finnair and Jet Airways. This analysis was used to provide a summary of issues faced by IAG followed by an evaluation of the steps that can be taken by IAG o improve its position including M&a opportunities, equity and debt capital raising options.

Table of Contents

Chapter 1: Introduction

Statement of the Problem

Purpose of Study

Rationale of Study

Overview of Study

Chapter 2: Review and Discussion

Chapter 3: Methodology

Description of the Study Approach

Data-gathering Method and Database of Study

Chapter 4: Data Analysis

Chapter 5: Summary and Conclusions

British Airways is currently owned by a holding company by the name of International Airlines Group, a group that also owns Iberia, an air carrier in Spain, with a merger between the two airlines expected to receive formal approval in the very near future. At present, International Airlines Group (IAG), through its subsidiaries, provides international and domestic air passenger and cargo transportation services throughout North and South America, Europe, Africa, Asia, Australia and the Middle East. Notwithstanding this far-flung global presence, the aviation industry continues to struggle with skyrocketing fuel costs, heated collective bargaining negotiations and cut-throat competition from regional carriers that can make profitable operations a challenge enterprise for larger carriers in particular. In this environment, providing financial analysis benchmarks for major carriers such as the still emerging IAG represents a timely and valuable enterprise, which is the problem considered by this study which is discussed further below.

Statement of the Problem

In an action that has been described by some analysts as "two drunks holding each other up," the merger between Iberia and British Airways will inevitably have some significant effects on the group's overall financial performance in ways that are difficult to predict, but which can be evaluated to some extent through an analysis of existing performance data, an enterprise that represents the purpose of this study and which is discussed further below.

Purpose of Study

The purpose of this study was two-fold as follows: (a) to review the relevant peer-reviewed, scholarly and industry literature and (b) to calculate and benchmark relevant financial analyses of IAG compared to three of its competitors, Turkish Airlines, Finnair and Jet Airways provide a summary of issues faced by IAG followed by potential steps to improve its position including M&a opportunities, equity and debt capital raising options

Rationale of Study

Analysts typically use two components of a company in evaluating its capital funding: cost of debt and cost of equity (McClure, 2010). The salience of using these two metrics to achieve the above-stated research purpose is congruent with one financial analyst who emphasizes, "Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debtholders, so WACC tells us the return that both stakeholders - equity owners and lenders - can expect. WACC, in other words, represents the investor's opportunity cost of taking on the risk of putting money into a company" (McClure, 2010, para. 2). Moreover, analysts who are interested in valuation employ the WACC method as well as for applications of the discounted cash flow analytical method (McClure, 2010). In addition, the WACC metric can be used as a benchmark to compare return on invested capital performance as well as in economic value added (EVA) analyses (McClure, 2010). According to one industry analysts, "Investors use WACC as a tool to decide whether to invest. To be blunt, the average investor probably wouldn't go to the trouble of calculating WACC because it is a complicated measure that requires much detailed company information. Nonetheless, it helps investors know the meaning of WACC when they see it in brokerage analysts' reports" (McClure, 2010, para. 3).

Overview of Study

This study used a five-chapter format to achieve the above-stated research purpose. Chapter one of the study was used to introduce the topics under consideration, provide a statement of the problem of interest as well as the purpose and importance of the study. Chapter two of the study presents a critical review of the relevant and peer-reviewed literature, and chapter three describes more fully the study's methodology, a description of the study approach, the data-gathering method and the database of study consulted. Chapter four is comprised of an analysis of the data developed during the research process and chapter five presents the study's conclusions, a summary of the research and salient recommendations.

Chapter Two

Review and Discussion

Global Aviation Industry Market Overview and IAG's Competitive Position.

In their report of the global airlines' premium traffic performance in November 2011, the International Air Transportation Authority (IATA) noted that demand for premium travel had increased slightly; however, it remained slower than the benchmarked year-to-date growth rate. By contrast, demand for economy class travel was on the rise, indicating a weaker passenger yield mix (Emsellem, 2011). The key route regions relevant to the Asia Pacific airlines, Europe-Far East premium traffic increased a modest 3%, which was regarded as a bright sign but which still was far below what IATA projected for this period (Emsellem, 2011). Generally speaking, the IATA currently projects limited growth in premium traffic in the near future characterized by the following trends.

1. Global premium traffic growth picked up in Nov, up 2% year-to-year compared to no growth in October; however, this rate was still less than the year-to-date growth of 6% year-to-year.

2. The level of premium traffic has also fallen 3% below its 2011 peak in May 2011, driven by the reduction in business travel on the back of weaker economic conditions and passengers switching from premium to cheaper economy class travel.

3. Economy travel did better, rising 3% year-to-year and has generally done better than premium demand in the second half of 2011, indicating weaker passenger yields for the airline sector.

4. Premium traffic growth within Far East routes (which accounts for 11% of global premium traffic and 6% of revenue) stalled in Nov, versus. its 4% year-to-year growth in Oct and 9% growth year-to-year year-to-date, which was disappointing. Premium traffic on Europe-Far East routes (10% share of global premium traffic and 16% of revenue) rose 3% year-to-year, ahead of its 1% growth in October but weaker than its 9% growth year-to-year year-to-date which is surprising given Europe's economic issues but IATA expects "export activity from Central & Northern European markets to drive some of the premium travel strength" on this route.

5. Premium traffic growth accelerated on North and Mid-Pacific routes (6% share of global premium traffic and 13% of revenue), up 5% year-to-year in Nov vs. its 2% rise in Oct and 4% growth year-to-year year-to-date which is positive.

6. Premium traffic on North Atlantic (Europe-America) routes (16% share of global premium traffic and 24% of revenue) was steady year-to-year in Nov vs. its 2% decline in Oct and 7% growth year-to-year year-to-date.

7. Overall, IATA expects little further growth in premium travel in the next few months which underpins their view that yields will likely decline in 2012 and the below-consensus earnings forecasts for most of the Asian airlines (Emsellem, 2011, p. 5).

The trends in premium and economic class for January 2003 through August 2011 upon which these IATA projects are based are depicted in Figure 1 below.

Figure __. Premium and economic class trends: December 2003 through August 2011

As noted in the introductory chapter, although the situation is highly dynamic, at present, British Airways is owned by International Airlines Group, a holding company called that also owns Iberia in Spain (Evans, 2011). The current situation has three main airline groups in place in Europe: (a) British Airways/Iberia, (b) Air France/KLM and (c) Lufthansa (Evans, 2011). In the future, though, current signs indicate that International Airlines Group will purchase additional aircraft for British Airways as well as Iberia but it remains unclear where these additional aircraft will be maintained and serviced (Evans, 2011). The current situation also shows that International Airlines Group is among the world's largest airline groups with 348 aircraft servicing 200 destinations and carrying more than 50 million passengers annually (About IAG, 2012). In addition, based on revenues, IAG is currently the third-largest airlines group in Europe and the sixth largest in the world (About IAG, 2012). Both British Airways and Iberia belong to the one-world alliance (About IAG, 2012).

The existing corporate structure of IAG can be traced to January 2011 when IAG became the parent company of British Airways and Iberia; the Spanish registered parent company has shares traded on the London Stock Exchange and Spanish Stock Exchanges with corporate headquarters in London (About IAG, 2012). The company's promotional literature emphasizes the synergistic effects of this corporate structure: "IAG combines the two leading airlines in the UK and Spain, enabling them to enhance their presence in the aviation market while retaining their individual brands and current operations. The airlines' customers benefit from a larger combined network for both passengers and cargo and a greater ability to invest in new products and services through improved financial robustness" (About IAG, 2012, para. 2). These changes in the corporate structure are consistent with larger trends in the airline industry which has experienced increasing consolidation among major carriers notwithstanding some regulatory constraints, and are also congruent with IAG's stated mission to "play its full role in future industry consolidation both on a regional and global scale" (About IAG, 2012, para. 3).

2.

Market perception of IAG as a whole

Some recent media reports provide some useful insights concerning the standing of IAG in the current competitive airlines environment. For instance, Brummer (2011) reports that in IAG still plans to proceed with a partnership with American Airlines in spite of the carrier's current status in federal district bankruptcy court. This is not all that surprising, Brummer suggests, because, "In the U.S. skies Chapter 11 [bankruptcy] is a way of life, and post 9/11 most of the major carriers, including United and Delta, shed their debts and found merger partners. Houston-based American Airlines was the exception until earlier this week when it filed for Chapter 11 in a bid to free itself of $30 billion of debts and costly contracts with pilots and other staff groups. The big difference in the case of AA is that it has an antitrust immunity deal with International Airlines Group, the owner of BA, so its affairs are of a real consequence to the flag carrier" (p. 93).

In reality, the completed merger action does have some significant benefits for IAG if American Airlines succeeds in reorganizing under the protection of the bankruptcy court and overcomes its labor problems (an issue that remains uncertain as this is written), making it a good North American match for IAG to help it achieve its corporate goals. In this regard, Brummer reports that, "The ideal outcome for Willie Walsh, who is now seeking to build IAG into a world beater, would be one which allowed BA to merge with its American partner; however, there is a big obstacle in the way in the shape of the U.S. restriction on share ownership in airlines which would limit IAG-BA to a 25% stake. Nevertheless, IAG has not entirely lost hope that the U.S. authorities and Congress might yet sweep the restriction into the sea making a merger possible" (Brummer, 2011, p. 93).

Many observers question whether such congressional approval is readily forthcoming, but most agree that the IAG merger is representative of the consolidation trends that have characterized the airline industry in recent years. For instance, Brummer concludes that, "There is an increasing recognition among the U.S. carriers that they risk being left behind by the big European airlines such as Lufthansa and IAG. They also face competition from new players, with limitless state money behind them, like Etihad, Emirates and Singapore. The pressure for change is gathering speed" (2011, p. 93). Taken together, the foregoing trends indicate that IAG is continuing to build a global concern in the face of increasing pressure from other major carriers that enjoy significant government subsidies and support, issues that affect the market perception of IAG. As reflected in the company's stock performance for the past year to date as shown in Figure 1 below.

Figure __. Stock Performance of IAG: Past YEAR-to-DATE

Source: http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary / company-summary-chart.html?fourWayKey=ES0177542018GBGBXSET1

Both carriers have struggled to compete with budget airlines and the decline in demand for premium business travel during the recession. Like its competitors, British Airways also attempted to reduce costs; however, this action resulted in cabin crews striking and in early 2010, the airline conceded that the costs of the labor issues could cost it as much as [pounds sterling]45 million (Tobin, 2010). Indeed, budget-carrier Rynair's CEO Michael O'Leary characterized the merger thusly: "This is two drunks holding each other up at the bar. "It's bad news for BA passengers as the company will now hike up the fares but good news for Ryanair as more passengers will switch from both to us" (Tobin, 2010, p. 37).

Other events have also affected the company's standing compared to its competitors in recent months, weeks, and in some cases, days. For instance, according to Smith (2010), recent reports indicate that the International Airlines Group consisting of the new merger between British Airways and the Spanish carriers Iberia may lead to the acquisition of another carrier, Bahrain-based Gulf Air (Smith, 2010). According to this industry analyst, "The airline, which flew almost six million passengers last year, currently has 24 super-jumbo Boeing 787s, 20 A330s and seven A320s on order. However, delivery of the 787s is being delayed to 2019 and there are reports that the carrier may shift its Airbus orders to smaller, narrow-bodied aircraft as part of a move to develop a more focused regional strategy" (Smith, 2010, p. 33). This reaction is congruent with the overall trend in the industry towards consolidation and may represent a valuable opportunity for carriers that identify strategic partners with the requisite resources and expertise that is needed in an increasingly competitive marketplace (Smith, 2010). Moreover, IAG's executive leadership team emphasized the importance of such initiatives to the company in the future and indicated they would be relentless in their efforts (Webb & Rothwell, 2012).

3.

Impact of recent corporate developments for IAG.

A report from Tobin (2010) indicates that British Airways merger with Spain's Iberia air carrier took place when British Airways was in the process of formulating a 3.7-billion pound recovery plan that appears to have resolved many of the same types of problems that are still facing IAG's intended North American partner at American Airlines. According to Tobin (2010), "Strike-ridden BA said talks with members of the Unite union had, for once, gone well and it had agreed a plan with staff and pension scheme trustees to cut its massive deficit without closing its two final-salary pension schemes. The negotiations were the last remaining barrier to BA's merger with Iberia to form International Airlines Group, an industry giant operating 1700 flights a day" (p. 41). This initiative was widely regarded as crucial to the eventual merger process itself because Iberia had ensured a legal right to withdraw from the negotiations if British Airways failed to develop a viable recovery plan (Tobin, 2010). The recovery plan stipulated that:

1. British airline would maintain its current annual distribution of [pounds sterling]330 million a year towards the pension schemes, with inflation-level increases every year, averaging about 3% continuing until 2023 for British Airways' older plan,

2. The Airways Pension Scheme, which ran from 1948 to 1984, and until 2026 for the New Airways Pension Scheme, which was open to employees between 1984 to 2003, when BA stopped offering staff a final-salary retirement plan.

3. The airline also agreed to make extra deficit contributions if its year-end cash balance was more than [pounds sterling]1.8 billion (Tobin, 2010).

These arrangements proved satisfactory and IAG executive leadership team even began conceptualizing what steps they should take following the all-but-completed deal with Iberia. For instance, a follow-up report from Laing (2010) notes that British Airways chief executive Willie Walsh compiled a list of twelve air carriers he considered possible targets for acquisition following the successful merger with Iberia.

Another report from Davies (2010) described the original negotiations as "acrimonious" but suggested the end of the tunnel is in sight with the imminent merger due to take place as these words are written. According to Davies, "British Airways has had a rum old year. Increasingly acrimonious dogfights with trade union United and cabin crew offshoot Bassa were swiftly followed by a record [pounds sterling]531m annual loss. Equally time-consuming, albeit for happier reasons, has been BA's [pounds sterling]5bn merger with Iberia to form International Airlines Group, alongside a revenue-sharing agreement with the Spanish carrier and American Airlines on lucrative transatlantic routes" (p. 66).

Interestingly, some analysts characterize the IAG merger effort as continuing the wave of consolidation that is taking place in the industry and characterize the most recent effort by IAG as merely representing a way to "spread the blame around" in case something else goes wrong. In this regard, Davies adds that, "Even for a renowned workaholic such as chief executive Willie Walsh, it's been a year of hard graft. And when times get tough, there is safety in numbers. The wooing of new bedfellows in the form of Iberia and AA is the first in what could become a torrent of tie-ups in the global aviation business. In the past decade, the world's airlines were profitable in only three years. These losses, amounting to some $50bn ([pounds sterling]31.6bn), are clearly an unsustainable trend" (p. 66).

With respect to the consolidation, the IAG CEO stated, "Our industry has to address the structural problems that exist. Consolidation is not the solution but it is part of the solution" (Walsh quoted in Davies, 2010, p. 66). While the CEO was upbeat about the initiative, Davis was more forthright in his assessment of the move: "Unkind observers might liken a global deal-making merry-go-round to a group of drunks propping one another up at the bar. But there is method in the merger madness" (2010, p. 66). Confirming the rumors that Walsh have developed a list of a dozen other potential acquisitions for IAG, Davies (2010) also reports that some of the targeted companies were amenable to such actions given the arrangements provided for the Iberia and British Airways move and salient details of the merger are set forth in Table 1 below.

Recap of details of merger:

Table

Recapitulation of BA/Iberia merger details

Metric/Category

Details

Combined market value

The combined market value of the merged airlines is [pounds sterling] 5.3 billion

Headquarters

London

Operations

Both carriers will still fly under existing brands, run from dual hubs in Madrid and London.

Aircraft

Destinations

205 airports

Passengers per year

61.5 m

Flights per day

Staff

60,282

Turnover

[euro]: 15 billion [pounds sterling]: 13.1 billion

Pretax profit (2009/10)

BA expected to post average full-year pre-tax loss of [pounds sterling]578m; Iberia posted [euro]435m pre-tax loss in 2009

Source: Adapted from Tobin, 2010

4.

IAG's financial projections and valuation analysis

Deutsche Bank reports operating profits for IAG were up 114% during 2011; however, even this healthy increase was more sluggish compared to current year project (a decline of 17% in 2012) and an expected operating profit increase of 122% in 2013 (van Klaveren, 2012). According to one industry analyst, "Airline earnings are always lumpy and volatile. IAG is no different. This is clearly because they are affected by multiple external effects that are difficult to forecast and cannot be mitigated in the very short-term" (van Klaveren, 2012, p. 5). Fourth quarter 2011 and Fiscal Year 2011 forecast summaries for IAG are presented in Table __ below.

Table

IAG 4Q11E and FY11E forecast summary

Based on the foregoing trends, it is apparent that premium demand is on the increase in 2012 and similar trends have been experienced in air carriers in the United States, Asia and Europe as well.

IAG's Current Capital Structure

The company's legal structure is depicted graphically in Figure __ below.

Figure 1. IAG Legal Structure

Note:

1. The National Control Structures have majority voting rights, however, 100% of the economic value of Opcos passes to IAG.;

2. Nationality structures in place in order to protect nationality agreements; and,

3. Cross-holdings between BA and Iberia Opcos to remain in place after the merger (Overview of consolidation, 2012).

Nationality Structures and Control:

1. At Operating Company shareholder level, the UK Trust/SNC has a majority of votes, but the ability to exercise control is limited as follows:

2. UK Trust/SNC votes limited to matters required by law (eg. approval of accounts); and,

3. UK Trust/SNC is obliged to vote as directed by IAG (subject to exceptions such as Assurances; Interests of national shareholders);

4. IAG has the right to refer disputes with the UK Trust/SNC to its shareholders for a 'magnified vote' (except for matters referring to Assurances).

5. At IAG Board level, if IAG issues a recommendation/direction to any directors, relevant directors must follow that (subject to Assurances and fiduciary duties).

6. All economic value of the Operating Companies flows to IAG. (Overview of consolidation, 2012).

IAG acquisition accounting

The transaction is the merger of two equals, however International Financial Reporting Standards (IFRS) requires that an acquiree and acquirer are identified. The company has concluded for this requirement British Airways is deemed to acquire Iberia; as a result, the Group balance sheet of IAG will reflect:

1. The book value net assets of BA, as they are currently reported, since BA is deemed acquirer.

2. The net assets of Iberia at their fair values on the date of the transaction.

3. The difference between the book value of net assets and the fair value of Iberia will be reflected as part of the purchase price allocation (Overview of consolidation, 2012).

Accounting implications of the merger steps Group and stand-alone balance sheet for IAG, British Airways and Iberia

A summary of issues faced by IAG followed by potential steps to improve its position including M&a opportunities, equity and debt capital raising options;

Purchase Price Allocation (Goodwill)

IFRS 3 requires that "as of the acquisition date, the acquirer shall recognise, separately from goodwill, the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree." Under IFRS, the acquisition date is the date at which the acquirer effectively obtains control of the acquiree (21st January 2011).

Recognised items reviewed

Analysis of the main assets already accounted for in each balance sheet line and identification of the applied valuation methodology

1. Intangible assets

2. Property, plant and equipment

3. Investments in associates

4. Non-current assets

5. Deferred tax assets

6. Non-current assets held for sale

7. Inventories and receivables

8. Current financial assets

Non-Recognised items reviewed

Identification of potential assets, not recorded in the financial accounts, but subject to be included and which comply with IFRS requirements

1. Slots

2. Brands

3. Code-share agreements

4. Franchise agreements

5. Frequent Flyer program

6. Other relevant contracts

7. Operating and financial leasing

8. Other assets (Overview of consolidation, 2012).

Chapter Three:

Methodology

Description of the Study Approach

As noted in the introductory chapter, this study used a mixed methodology to achieve its stated research purpose. The first part of the study approach used a review of the relevant literature to develop the background and industry information needed to complete the second part of the methodology which was to calculate the WACC as described below. This approach is consistent with the guidance provided by numerous social researchers who emphasize the need to review what is known about a given topic in order to formulate new insights and identify gaps in the existing body of knowledge. For example, Wood and Ellis (2003) identified the following as important outcomes of a well conducted literature review:

1. It helps describe a topic of interest and refine either research questions or directions in which to look;

2. It presents a clear description and evaluation of the theories and concepts that have informed research into the topic of interest;

3. It clarifies the relationship to previous research and highlights where new research may contribute by identifying research possibilities which have been overlooked so far in the literature;

4. It provides insights into the topic of interest that are both methodological and substantive;

5. It demonstrates powers of critical analysis by, for instance, exposing taken for granted assumptions underpinning previous research and identifying the possibilities of replacing them with alternative assumptions;

6. It justifies any new research through a coherent critique of what has gone before and demonstrates why new research is both timely and important.

Similarly, Silverman (2005) advises that a critical literature review should aim to answer the following questions:

1. What do we know about the topic?