At first blush, the valuation of British Airways’ parent IAG (LSE: IAG) looks very cheap. The IAG share price is less than four times last year’s earnings per share. A price-to-earnings ratio of under four can certainly suggest a company is in bargain territory.
Is that the case for IAG – and ought I to add it to my portfolio?
Highly variable earnings
Although the P/E ratio based on last year’s earnings was less than four, that reflected an unusually strong profit performance from the airline company. Basic earnings per share jumped over sixfold from the prior year. The two years before that had seen IAG report sizeable losses.
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Variable earnings are part and parcel of the airline industry. Cost factors such as fuel prices can have a big effect but are basically outside airlines’ control, though carriers can buy contracts to mitigate the impact of sudden short-term jumps in price. Meanwhile, external events from volcanic clouds to travel restrictions can see demand move around suddenly.
This year has started strongly for IAG. Basic earnings per share for the first six months were within 2% of the figure for the same period last year. For the full year, IAG expects strong travel demand in its core markets and significant free cash flow generation.
It means that not only is the historical P/E ratio low, the prospective one is too, at least in the short term.
Improving balance sheet
Earnings are only one part of how to value a company. Spending obligations matter too. So a firm’s cash position is important.
In its half-year results this month, IAG said it expects to “maintain a strong balance sheet” for the rest of the year. I would hardly characterise the balance sheet as “strong“. At the interim point, the business had net debt of €6.4bn.
Still, while that is a lot of debt, it marked a significant improvement from the halfway point last year, when net debt stood at €9.2bn.
The company’s performance lately has enabled it to cut its net debt, something I see as positive for the investment case.
Is this a bargain?
So is the IAG share price super cheap? For one thing, that debt is significant. So looking just at the P/E ratio does not tell the full story. That said, earnings are strong and look set to stay that way, for now at least. With well-known brands, ongoing strong passenger demand and a leaner cost base than it used to have, IAG has some strengths as a business.
Then again, in many ways that leaner cost base has come at the cost of the passenger experience. My own experiences flying British Airways in recent years have reduced not increased my own loyalty as a passenger.
Airline demand is highly unpredictable over the medium term as it can suddenly drop without warning, as we have seen repeatedly.
To see the share price as super cheap, I think confidence is required that demand and revenue outlook in coming years will be buoyant. There is a risk it will not be, so I do not have that confidence. I will not be buying IAG shares for my portfolio.
