A 60% slump in quarterly profits is usually seen as bad news. But shares in British Airways owner International Consolidated Airlines Group (LSE: IAG) rose slightly on Friday, after the company said its adjusted operating profit for the first quarter fell by 60% to €135m.
City number crunchers seemed to agree with IAG boss Willie Walsh’s view that this was a credible performance during a difficult three months.
Flying against the wind
Mr Walsh said that his airlines faced headwinds from rising fuel costs and unfavourable exchange rate movements during the quarter. He reported a 15.8% rise in fuel unit costs, which is a measure of fuel costs per seat-kilometre flown.
Changing exchange rates also worked against the airline, cutting operating profit by €61m compared to the same period last year.
These headwinds aren’t a surprise, but they highlight a serious risk that we need to consider before investing in airline stocks. Passenger numbers have grown strongly in recent years, but this has happened against a backdrop of lower fuel costs and cheaper ticket prices.
Will people keep flying if ticket prices rise, or will airlines be forced to accept lower profit margins in order to fill seats? We don’t yet know, but I was encouraged to see that IAG sold 83.4% of available tickets in April, compared to 81.9% in April 2018.
Another positive was that the biggest improvement was on long-haul routes to North America, Asia, the Middle East and Africa. That’s good news, because IAG’s airlines rely on long-haul routes and premium class seats for a lot of their profits.
The right time to buy?
IAG has been transformed over the last decade, through a number of big acquisitions. It’s very hard to say what a suitable valuation for the group might be during a downturn. But the shares currently trade on just 5.1 times 2019 forecast earnings and offer a 5.9% dividend yield.
This suggests to me that the stock is already priced for falling profits. We don’t know how this year will play out. But in my view, IAG shares look decent value at about 500p. For long-term investors willing to ride out any storms, I think now could be a good time to buy.
A better alternative?
Would budget airline easyJet (LSE: EZJ) be a better buy? The group’s focus on low-cost and short-haul has helped it grow into a FTSE 100 business, without losing its identity.
However, recent updates suggest it’s suffering similar problems to IAG. In April, easyJet said that comparable fuel costs for the six months to 31 March would be about £37m higher than last year, while exchange rate movements would cost the firm about £8m.
What about Brexit?
To continue flying between EU nations after Brexit, airlines such as easyJet are required to have a majority of EU shareholders, excluding UK investors.
easyJet recently reported 49.92% EU ownership, excluding UK investors. That seems fine to me, especially as the EU Parliament has committed to making sure that flights aren’t disrupted after Brexit.
What I’d do
With easyJet shares trading at about 1,000p and offering a 4.8% dividend yield, my view is that the orange-topped airline is probably a long-term buy.
Although the short term looks uncertain, I’m confident this focused and profitable business will continue to adapt and prosper for many years to come.
