Aircraft have weight restrictions and so, too, do corporate balance sheets. International Consolidated Airlines Group has been on a fundraising spree over the past 12 months, trying to bolster its reserves as travel restrictions have caused severe falls in passenger numbers. Its net debt has spiralled from €7.6 billion at the end of 2019 to €12.1 billion.
It has little choice but to bear that burden. Despite slashing operating costs, tumbling passenger numbers meant that over the first six months of this year it reported a €2.3 billion pre-tax loss and a €1.1 billion cash outflow from its operations. British Airways, the most prominent of IAG’s stable of airlines, accounted for the worst of the losses, hampered by travel restrictions and, in particular, limits on transatlantic travel.
The company has been hit more severely than Ryanair and Wizz Air, its London-listed peers, because of its exposure to long-haul travel, which has been especially hindered by travel restrictions. Forecasts for a recovery in passenger numbers, and therefore earnings, for the low-cost airlines are also speedier.
That’s reflected in investors’ stingier attitude towards the shares. IAG’s enterprise value sits at just under five times forecast earnings before interest, tax and other charges for 2023, which most analysts think will be the first year of completely “normal” trading. But when compared to its history, that multiple actually doesn’t look meagre at all, which suggests the market is buying into a story of earnings recovery to pre-pandemic levels by that year.
Perhaps investors could benefit from a greater dose of caution. It is not a surprise that IAG does not have an investment grade credit rating. In September, Moody’s, the ratings agency, downgraded IAG’s credit rating to Ba2, citing its large exposure to long-haul, cross-border and corporate travel and the “challenges to recover the balance sheet and de-lever in the next two to three years”.
At €10.8 billion, liquidity is higher than the pre-pandemic level and represents 42 per cent of IAG’s 2019 revenue. That’s just as well, because flight capacity is expected to rise to only 45 per cent of 2019 levels during the present quarter, although that would be up from 21.9 per cent during the previous three months. IAG might say it’s ready to fly as much as 75 per of its pre-pandemic capacity by the final quarter of this year, but the actual level will depend on government policy, so really it’s anyone’s guess. The group also has assumed that transatlantic travel will recommence both ways during the third quarter of this year — and that’s not happened yet, either.
While it looks as if IAG has the funds to see it through reduced capacity, debt — to state the obvious — needs paying back. To its credit, the bulk of the group’s debt is not due for repayment until 2026, although €626 million does mature in November next year. A refinancing of that debt looks likely.
But heavy debts do eventually put more demands on the earnings you generate. If you’re looking to boost profits, it also inhibits your ability to discount fares to win new business. And it leaves less cash for shareholder returns. Most analysts do not see IAG paying a dividend until 2024, in any case.
There’s also the question over whether another rights issue will materialise eventually. Given the level of cash and debt resources on the balance sheet, IAG has said that it doesn’t have any plans at present. Nevertheless, it may think it expedient to tap the market for cash at some point.
When you can pick up less risky low-cost carriers at valuation multiples not that much higher than IAG, there are better ways to play the reopening recovery.
ADVICE Avoid
WHY High debt and uncertain recovery in revenue is not compensated enough in the shares’ valuation
Inchcape
Inchcape gets annoyed if you lump it in with pure-play car salesmen. That’s because it sees higher-margin distribution as the bigger prize, dispersing new and used vehicles worldwide on behalf of manufacturers, including Mercedes and Volkswagen, selecting and managing the dealership network under the Inchcape banner.
Recovery from the pandemic slump in revenue is coming faster than management expected, partly thanks to some pent-up demand, partly from its ability to increase pricing on new vehicles amid a supply shortage. The market has noticed and the shares have rebounded to their highest level since 2015, or 17 times forecast earnings for this year.
A tighter supply from manufacturers could be a challenge during the second half, but it’s not stopped the FTSE 250 group raising pre-tax profit guidance for 2021 twice so far this year. The consensus forecast for adjusted pre-tax profits stands at £258 million, more than twice the 2020 level but still 21 per cent below pre-pandemic numbers.
Inchcape is looking at two areas for earnings growth. First, by targeting smaller and more fragmented distribution markets, including countries in Latin America and Asia, where it doesn’t make economic sense for vehicle manufacturers to set up their own operations. It reckons it can drive up earnings faster, organically and via acquisitions. Second, it wants to gain more of the after-sales market, everything after the sale of a vehicle, from routine servicing to accident repair, finance and insurance via third-party providers.
It’s a capital-light and cash-generative business, which means there’s potential. Over the first six months of the year it churned out £184 million in free cashflow, prompting a £100 million buyback and a reinstated interim dividend at 6.4p a share.
Peel Hunt raised its target price on the stock to £10 after the first-half results, against the present share price of 890p. About half of the cost savings made in the depths of the pandemic are expected to stick in the longer term, which bodes well for further gains in profit margin.
ADVICE Buy
WHY Chance for further re-rating in the shares from high growth distribution markets
