IAG surprises the market (and itself) with positive Q1 results

The first profitable Q1 since 2019

Last week IAG reported an operating profit of €9m for the first quarter of 2023. This was something of a milestone for what is typically the company’s weakest quarter. The last time they reported a Q1 operating profit was back in 2019. However, the company was still loss-making after finance costs, with a pre-tax loss of €121m.

What was more striking was how much better the results were than expected. On February 24th, IAG gave guidance for Q1 operating losses of €200m. At that time, there was really only one month left to go in the quarter. To come out with an actual result €209m better only 10 weeks later is quite frankly remarkable.

Disclosure and wealth warning

Before commenting further on the results, I need to warn you that nothing in what follows should be taken as representing investment advice (which I am not legally authorised to give). Everything that follows is, of course, based on publicly available information. Even if I had any inside information (which I don’t), I wouldn’t be legally allowed to share it. I should also disclose that whilst I sold most of my IAG shares after leaving the company, I still have a small holding, partly for nostalgic reasons. So I have a small financial interest in IAG’s share price going up from the pitifully low levels it has fallen to since the crisis (80% below the peak).

With that out of the way, let’s get back to the business of working out what happened to turn a €200m predicted loss into a €9m profit in such a short time.

How did IAG get its forecast so wrong?

The company said that about a quarter of the €209m outperformance, or about €50m, came from lower than expected fuel costs. €50m represents 2.7% of IAG’s quarterly fuel bill. With January and February already “in the can” when they made that forecast, that suggests they overestimated fuel costs in March by about 8%. In euro terms, spot fuel prices in the first half of March were actually a little higher than they were on Feb 24th. But on the 15th, they fell by about 10% and remained there for the rest of the month. So I would have thought an average effect for the month should have been more like 5%. IAG also commented that “Jet fuel supply contracts are typically based on pricing up to one month in arrears“, which I take to mean that lower commodity prices are only reflected in costs with a lag. So at the end of February, commodity prices ought to have been almost completely locked in, especially as IAG hedges short-term fuel prices heavily. Fuel costs will have been helped by the euro strengthening against the dollar. It did so by about 3% in March, but only in the last 10 days.

So it is hard to understand why the variance in fuel costs was as big as it apparently was. Perhaps the answer lies somewhere in the complex fuel and currency hedging arrangements. But I suspect that the guidance might also have been based on an assumption that euro fuel prices would rise, in the interest of being “conservative”.

What explains the other ~€150m of outperformance? Normally, it is revenue that surprises rather than costs, at least in the short-term. But if all of the non-fuel outperformance was revenue driven, that would mean they under-forecast Q1 revenue by 2.7%. On February 24th, they would already have known the actual results for the first half of the quarter. So that means they under-forecast the rest of the quarter by over 5%. That's quite hard to believe, given that most of the revenue must already have been booked at that point.

It therefore seems likely that a fair chunk of the outperformance was cost driven. Quite why IAG couldn't forecast costs accurately for a quarter they were already half way through is rather puzzling. Currency will have played a part, but as we’ve seen, exchange rate movements in March weren’t that significant. I suspect that it is not a coincidence that this was the first quarter of the financial year. IAG will have set its budgets for 2023 only a couple of months before its 24th February guidance. In a big company, people are usually reluctant to admit that they won’t manage to spend their hard won budgets so soon after getting them approved.

What does this mean for the full year outlook?

As far as the full year is concerned, IAG provided guidance on Feb 24th for operating profit in the range €1.8 - €2.3 billion. I commented at the time that this seemed low, with even the top of the range still being 30% lower than 2019. Following the better than expected Q1 results, IAG have now changed their outlook to "above the top end of previous guidance", so “more than €2.3 billion”. The last four quarters have totalled €2.0 billion, so that still seems like a soft target to me.

IAG defends its cautious stance by talking about "limited visibility of customer bookings for the second half of the year". The second half starts in July, less than two months away. I would be staggered if the company didn't already have a good idea for how revenue for Q3 was shaping up, at least for the long-haul parts of the business. Q3 should be already half sold at this point.

They also cite uncertainties about the outlook for fuel prices. They showed a sensitivity centred on $800 per tonne. The current forward price for the rest of 2023 is around $720, which would suggest an upside to fuel costs of more than €300m.

In Q1, operating profits were €126m below the same quarter of 2019. If that performance versus 2019 was maintained throughout the rest of the year, full year operating profits would hit €2.8 billion. It should also be noted that in 2019, Q3 was impacted by a strike at BA costing €155m. If you adjust the baseline for that, sustaining the Q1 performance versus 2019 would get you to a full year profit of €2.9 billion. Add in the fuel upside and I would have thought they should be shooting for at least €3.2 billion.

We can also get a range for profit using the other figures IAG cited on the analyst call. IAG said that Q1's 14% passenger yield increase versus 2019 is "holding up quite well" going into the summer. I've taken that to mean that the same performance will be repeated in Q2 and Q3. I’ve reflected a weakening of 5 points in Q4. At some point lower fuel prices will start to feed through into ticket prices. I've assumed cargo yields progressively weaken each quarter as the market normalises with returning wide-body capacity. I've coupled this with an assumption for non-fuel unit costs at the most conservative end of IAG's guidance. That was for costs to be 6% down on 2022 for the year as a whole (Q1 was 14% better). With a fuel assumption for the rest of 2023 of $720 per tonne and current exchange rates, these assumptions give an operating profit outlook of €2.7 billion. If non-fuel costs come in at the top end of guidance (10% reduction), then operating profit would hit €3.5 billion.

I still think this leaves room for further upside. Other airlines have talked about Q2 and Q3 being stronger than Q1. If that translates into another 2.5 points of yield for the rest of the year, that would give us another €400m of profit, so €3.1 - 3.9 billion.

To get to a figure as low as the bottom end of IAG’s range (€2.3 billion), you'd need to see cost performance at the low end of guidance, to use the more conservative passenger yield assumptions and for fuel prices to climb quickly back to around $900 per tonne. Could that happen? I suppose so. But if IAG can deliver a cost performance in the middle of its range, current yields hold up and fuel prices don't rise again, I would have thought €3.5 billion is a better guide for expected outlook.

That would be marginally higher than the €3.3 billion achieved in 2019 and would be a great result in many ways. But it would still be below 2019 in real terms, adjusting for the circa 20% of cumulative inflation since then. Interest costs are also up a lot due to the debt taken on during the pandemic, so operating profit needs to be higher if all that debt is to be serviced and paid back.

Why is IAG being so cautious in its outlook?

There are two possible explanations for why the company is so reluctant to talk positively about prospects for 2023 results.

The first reason could be that management genuinely don’t have confidence and would prefer to err on the side of extreme caution. The second reason could be that pay negotiations are still on-going with trade unions in some of IAG’s subsidiary airlines. To admit openly that profits could match or beat pre-pandemic levels this year would weaken their negotiating position. It would be disastrous to give pay awards based on benign assumptions about yields and fuel prices if things turn out to be closer to the “worst case” end of an admittedly large range of possible outcomes.

In any event, I suspect we won’t see much public optimism from management until labour negotiations have concluded.

Share price reaction

Despite beating expectations by more than €200m in Q1, IAG's share price only edged higher. Prior to the release of the results, the analyst consensus for 2023 operating profit was around €2.2 billion, so I guess the new guidance of "more than €2.3 billion" didn't excite the market.

If I'm right and the true outlook is more like €3.5 billion, then there is a lot of upside potential in the shares. Perhaps the market will wake up to this once analysts have had a chance to adjust their models. The only update I've seen so far was to €2.9 billion, which suggests that analysts are being cautious.

Analyst and investor caution is understandable, given IAG's unwillingness to speak any more optimistically about the outlook. And confidence is certainly not helped by the company's apparent inability to forecast profitability, even for a quarter which they are already half way through.