I started my career in the credit market. This means I pay great attention to the balance sheet and the Altman Z-score when looking at companies. It’s also my opinion that the bond markets are more disciplined than equity markets. They are just looking to get their money back with a fair yield. They are relatively pessimistic versus the optimists in the equity market, who tend to be income statement and story driven.
So, on the face of it, you might be surprised that I own International Consolidated Airlines Group (LSE:IAG, Financial). It has a weak balance sheet and an Altman Z-Score of -0.3. The pandemic has created great uncertainty for international air travel. The equity market’s conventional wisdom is that the stock is one to avoid thanks to its high debt, and the uncertainty around the sustainable recovery in revenue is not compensated for in the stock’s valuation. Even my beloved GF Value chart puts the stock at significantly overvalued (on the other hand, the equally credible Morningstar Style Box does classify the stock as mid-value). At a Shiller price-earnings ratio of 8.2, the stock does look cheap.
Ultimately, however, I have a variant perception, which is that the world will recover fairly quickly from the pandemic and things will normalize in a year or two. We’ll learn to live with Covid-19 just like we did with the flu, and life will go on. International travel will resume and eventually surpass previous levels.
I recently read two very interesting and cautiously optimistic articles about the pandemic from publications I trust and respect: The Economist and The Wall Street Journal. The Economist had a Briefing titled “How the world learns to live with Covid-19,” which was relatively certain the pandemic will turn into an epidemic. The Wall Street Journal had a very interesting article very recently titled “Endemic Covid-19 Has Arrived in Portugal. This Is What It Looks Like.” This article claimed that Portugal, thanks to high vaccination rates, has returned to a cautious normality already.
So while the global aviation market remains very challenging in the near term, and it remains very difficult to predict the pace and magnitude of the air traffic recovery and it is even harder to forecast fares, International Consolidated Airlines has taken radical action to cut costs, and this underpins my view that it can achieve attractive margins once the market begins to normalise.
I was looking at International Consolidated Airlines, also known as International Airlines Group or IAG, before the pandemic struck. The group was created in 2011 to bring together the British and Spanish national carriers British Airways and Iberia. The venture's aim was to continue the consolidation. In November 2019, the company announced a major deal to buy Air Europa.
The pandemic has delayed the completion of this acquisition and the European Commission has opened an in-depth investigation to assess the proposed acquisition of Air Europa by IAG, under the EU Merger Regulation. The Commission is concerned that the proposed transaction may reduce competition in the markets for passenger air transport services on Spanish domestic routes and on international routes to and from Spain. The Commission has until Nov. 5 to make a decision.
I’m not basing my investment on the basis of this, as the European Commission could well block the deal. However, the potential acquisition of Air Europa, if approved by the EU, could deliver strategic and financial benefits. IAG has a very strong record on acquisitions.
Pre-Covid, IAG was one of the most profitable airlines in Europe. By 2023-24, I think IAG can generate a 12-15% group Ebit margin, in line with its pre-Covid performance and goals.
IAG believes that when its capacity is back to circa 90% of 2019 levels, its non-fuel unit costs will be the same, or lower, than they were in 2019; this is due to significant structural cost savings it has achieved.
IAG raised over 8.6 billion Euros ($9.9 billion) in new debt and equity since April 2020 to boost liquidity and help it through its cash burn during a period when a significant percentage of its fleet was grounded. Using its financial statements as of June 30, 2021, I calculate the company has about nine months of liquidity if there is another 100% grounding of its fleet. Clearly at this stage it’s very unlikely there will be 100% grounding, so it appears to me that IAG has survived its gravest bankruptcy risk period. Leverage ratios will fall as Ebitda improves going forward.
IAG now has strong liquidity of €10.2 billion at the end of Q2, driven by successful conclusion of financing initiatives since the start of the year including €1.2 billion of IAG Senior Unsecured Bonds issued and €825 million of IAG Convertible Bonds issued. Both of these issues were oversubscribed, which shows the confidence the credit markets have in IAG.
The conventional wisdom is that IAG won't pay a dividend until 2024. Investors should not purely focus on dividends. The focus should be on total return, which is capital appreciation plus dividends. If IAG can get its business back to 2019 levels, the stock has 200% upside potential in my opinion.
