It was a sign of the remarkable twelve month run of International Consolidated Airline Group (LSE: IAG) that last week’s announcement of the company’s first dividend since its formation four years ago, a 40% leap in year-on-year third quarter profits, and increased profit expectations saw the stock drop 4% before recovering slightly over the course of this week.
IAG, the holding company for British Airways, Iberia and Aer Lingus, has risen 40% over the past year, and despite the raft of good news on Friday, many investors saw this as the end of the rise in IAG shares and sold off their holdings to realize profits. Should long-term investors think about buying shares now, or follow the City traders and flee via the emergency exits?
British Airways remains the star attraction in IAG’s stable of airlines and has contributed two-thirds of IAG’s profits this year. Wisely, BA, unlike many of its European legacy carrier rivals, has focused on developing profitable trans-Atlantic routes rather than being sucked into the fight over market share on the highly competitive flights from Western Europe to Asia.
However, the airline should worry about the increasing presence Middle Eastern carriers. These Middle Eastern rivals have already proven their ability to hoover up high-spending, high-margin business class flyers on Europe-Asia and Europe-Middle East routes, and I see little reason they will not be able to do the same on trans-Atlantic flights.
Iberia, the second largest airline in the group, has executed a much needed restructuring program, and since the merger the Spanish airline has slashed its bloated employee headcount by over 15% and cost per employee by 10%, while increasing productivity year over year. These actions have returned the airline to profitability this quarter and management has set ambitious targets to further lower costs, which remain more than a quarter higher than at BA.
Investors with a long memory will almost certainly agree with Warren Buffett’s famous aversion to holding shares in airlines. While the news out of IAG appears to be all sunshine and rainbows, investors would be wise to remember that the industry remains highly cyclical and fuel prices are almost guaranteed to rise again in the future. This will hit legacy carriers especially hard, as they are less able than discount competitors to cut labour costs due to strong unions.
Even after consolidation in the sector and increased cost controls, legacy carriers such as IAG still face high pension costs and ruthless competition from more nimble discount competitors such as Ryan Air and easyJet on the low-end and state-backed Middle Eastern carriers on the high-end.
Despite the good news coming from management, I would steer clear of IAG and other legacy carriers who remain at a competitive disadvantage to smaller rivals in this competitive industry.
