One FTSE 100 company with an almost unbelievably low-looking valuation is airline operator International Consolidated Airlines Group (LSE: IAG). The shares are perky today, up around 5%, as I write, on the release of the third-quarter results report, which delivered figures for the nine months to 30 September.
Revenue rose a little over 5% compared to the equivalent period last year, operating profit before exceptional items increased by 7.3%, and adjusted earnings per share moved 12.5% higher. During the period the firm completed a “second” €500m share buyback programme and the directors declared an interim dividend 16% higher than last year. The firm looks like it has made decent progress but today’s share price around 603p is some 10% below where it was a year ago.
How IAG has earned its low valuation
Chief executive Willie Walsh said in the report the results are “strong” despite “significant” headwinds from the cost of fuel and the variability of foreign exchange rates. So, with the underlying business performing well, why isn’t the share price higher? The forward earnings multiple for 2019 values the firm at around six times earnings and the forward dividend yield runs close to 4.5%. Cheap, at first glance, but does the firm deserve its low valuation?
I think it does. Revenue, earnings and cash flow have been advancing for several years, but the rate of growth in earnings has been declining: 95%, 79%, 27%, 12%, 9%, and City analysts following the firm are expecting a flat earnings result for 2019, so zero percent. Meanwhile, the price-to-earnings ratio has declined a little every year as earnings have been rising. It’s classic behaviour for a cyclical share. As profits rise, probably to their peak value, the stock market tries to anticipate the next cyclical plunge by trimming the firm’s valuation.
Who knows when fuel prices, currency rates and falling demand will pull the rug from IAG’s profits and send the shares into freefall? The worst time to buy a cyclical share like this is when the valuation is low after a long period of strong profits, according to one-time outperforming US fund manager Peter Lynch in his book Beating the Street.
A death trap for investors?
Meanwhile, the Oracle of Omaha, Warren Buffett, was very specific about airlines at the 2013 Berkshire Hathaway annual shareholder meeting. He said: “Investors have poured their money into airlines for 100 years with terrible results. It’s been a death trap for investors.” He had previously explained in his 2007 shareholder letter that “the worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines.”
Indeed, the industry is characterised by fierce competition and capital-intensity, and airlines such as IAG can do precious little to carve out a competitive advantage. I think IAG looks dangerous for investors right now so I’m avoiding the stock. However, I do think the current weakness in the stock market is a good opportunity to drip regular money into the market. But instead of taking on individual company risk by investing in IAG, I’d rather go for a FTSE 100 index tracker fund.
Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.