Willie Walsh’s last IAG results
Since IAG was formed nine years ago, the group's CEO Willie Walsh has been able to present a string of strong results, with profits rising steadily.
The pandemic-hit first half results for 2020 were not the figures he would have wished to be presenting as his last, ahead of his delayed retirement on the 8th of September.
However, he sounded in good spirits on the analyst call. I am sure he is looking forward to a well-earned break after what has been a punishing few months for airline management teams and employees alike.
First half results
First half losses before tax added up to €4.2 billion, or €2.1 billion before exceptional items, wiping out a good proportion of the €6 billion the group has earned over the previous two years.
Q2 pre tax losses weighed in at €1.5 billion before €812m of exceptional items, mainly comprising €731m of fleet write-downs driven by the decision to retire the 747-400 and A340-600 fleets at British Airways and Iberia respectively.
Beyond the headline losses, which were always going to be awful, the big question for Willie's last set of results was how well costs and cash could be managed. With capacity down by 95% and revenue declining by 89%, how fast could the group bring down costs to compensate?
Ryanair set an impressive benchmark last week, reporting operating costs down 85% in the quarter, benefiting from its highly variable cost structure. The only other European flag carrier to report so far is Air France KLM, which managed a 63% reduction.
With a 64% reduction, IAG managed to beat Air France - KLM, but only just. Let us look at some of the big cost components to see where IAG got the savings from and where they struggled.
Employment costs
In most years, employee costs are the second biggest cost category after fuel, representing just under 20% of revenue.
Employment costs of €656m in the quarter were down by 49% compared to last year. British Airways benefited from the UK government's furlough programme, which covers 80% of salaries for furloughed employees, but only up to a maximum of £2,500 per employee per month. Similar schemes were available in Spain and Ireland for the other group airlines. IAG disclosed that it received about €300m in total of government assistance from these schemes, covering about 31% of employment costs in the quarter. Excluding these government schemes, IAG managed to bring down employment costs by 26%, pretty similar to the US majors who reduced costs by 25% on the same basis.
However, the US airline industry benefited from a bespoke package of payroll assistance in response to the pandemic, covering about 70% of total employment costs for six months. If IAG had received payroll support as generous as was made available to airlines in the USA, the IAG results would have been more than €400m better in the quarter.
The decline in employment costs was pretty similar to Air France - KLM where they fell 50%. Doing as well as AF-KL wouldn’t be something that Willie would normally be pleased with, but I think it was quite good going since my understanding is that in France the state picks up 70% of gross remuneration of idled workers under the “partial activity scheme”. That will have been worth more to an airline with many highly paid pilots than the UK’s 80% support capped at £2,500 a month.
However, IAG’s performance wasn't that impressive compared to Ryanair, who managed to cut staff costs by 77% in the quarter and has started to ramp up capacity in Q3 quite aggressively.
What is more, the UK scheme has already starting to taper, whilst the US scheme continues until October and may get extended further. European schemes remain in place. That explains why IAG has been urgently pursuing labour cost reduction negotiations with its unions, especially at British Airways.
Other cash operating costs
Excluding employee costs and the non-cash "depreciation, amortisation and impairment" cost line, other operating costs fell by 67% in total, better than employee costs but still quite a bit less than the capacity and revenue decline.
Highly variable costs like fuel, selling costs, landing and handling fees fell in total by 86%, almost matching the revenue decline. But property, IT and other costs proved to be pretty fixed and only fell 14%.
In the "semi variable" category were "Engineering and other aircraft costs", which fell by 52%. With so many aircraft grounded in the quarter, it should have been possible to defer most maintenance and bring these costs down more. It looks to me like IAG decided to use the extra ground time to get ahead on its aircraft maintenance work, which will have benefits in aircraft availability later. Not all of this P&L expense will have been cash, as inventories of spares were run down by €147m in H1, only half which was down to write-offs related to fleet retirements.
Fuel hedging losses
There is another big cash drain which didn't go through the P&L in Q2, as it had been provided for as an exceptional charge in Q1. That is the cost of the "ineffective fuel and currency hedges" which may have been provided for in the P&L, but still need to be settled in cash.
A total of €1,166m was charged to P&L in H1 and €621m was reversed out as non-cash in the H1 cash flow statement. The difference of €545m gives you the cash losses in H1, all of which will have fallen in Q2.
These cash losses from fuel and currency hedges will begin to decline naturally in Q3 as the proportion of hedged fuel begins to drop and capacity increases. But better than that, I think that IAG has pushed some or all of the remaining €621m out of the second half and into 2021 in cash terms. In the notes to the non-operating cost section of the accounts, there was a reference to some pretty hefty charges for
"…arrangement fees and interest for new debt and facilities and costs associated with restructuring certain derivative contracts, for which the cashflows have been deferred to 2021 or later".
Whist this will be.a big help to cash in the second half, there will be a price to pay in 2021, probably in the form of higher fuel costs than would otherwise be the case.
Before we turn to the question of cash burn, we need to look at the revenue and working capital performance.
Cargo revenue to the rescue
Usually by far the biggest revenue category is passenger revenue. In Q2 last year, it made up 89% of total revenue. This year it fell by 97% and was overtaken by cargo revenue, which actually grew by 31% compared to last year.
The reason cargo grew was due to the global shortage of air freight capacity caused by the grounding of so many wide body aircraft, causing a spike in cargo yields which more than tripled versus last year. IAG joined the party by operating 1,875 cargo only flights using passenger aircraft - many with the seats removed to increase cargo capacity. IAG gave a figure for the incremental cash costs of these flights of €12m. Given that cargo revenue went up by €88m versus last year, that looks to have been a very good initiative, well executed.
Passenger revenue
Passenger revenue at €198m was quite a small item in the quarter, with capacity down 95% and load factors of only 28%. Interestingly, passenger yields more than doubled on both a per RPK and per passenger basis. That confirms what I had seen in public pricing - the company was clearly taking the view that any travel taking place was probably essential and pursued a strategy of maximising yield, letting the load factor turn out as it may.
However the real work on the passenger revenue front was in managing the working capital effects of a sudden cessation of flying, with customer refunds the biggest issue..
The money that customers pay for future flights lives on the balance sheet in the "deferred revenue on ticket sales" line and in December 2019 that account showed a balance of €5.5 billion. With a huge proportion of the flights cancelled, there was a real risk that a large proportion of this could turn into a cash outflow. That is the reason why airlines have been pushing so hard to slow down refunds until they could start to bring in new bookings to replace them, and to get customers to accept vouchers for future travel instead of a cash refund.
In the H1 accounts, we finally got to see how well IAG did in managing this potentially airline killing issue. Deferred revenue on ticket sales fell to €4.6 billion. That still represents a cash outflow of €862 million, but it could have been very much worse. We don't know how much of this outflow was in Q2 compared to Q1, but the prepaid flights balance would normally see a seasonal rise from December to March and like other airlines, IAG made a slow start to making refunds after the first mass-cancellations in March. So I believe that all of this cash outflow was probably in Q2.
Other working capital effects
IAG managed to bring down trade receivables (money due from agencies and other such items) by €1,464m in the first half, which more than offset the contraction in the deferred revenue account.
Overall working capital effects were actually positive €447m, with many actions such as deferment of lease payments and air navigation charges and the sale of loyalty points all contributing.
Whilst an impressive achievement, all these deferred payments will eventually have to be made and with the airline group likely to emerge from the crisis smaller than it went in, there won't be the scope to expand the forward sales again to the same extent.
Cash burn
Every airline seems to use its own preferred measure of cash burn and IAG is no exception. Its metric excludes revenue and working capital effects, but includes lease payments and they quote it on a weekly basis. On that metric, the quarter as a whole came in at €205m a week.
I wanted to compare performance to the big three US carriers, whose cash burn I have already looked at in this article. I've used the "American Airlines" definition, which excludes lease payments and includes revenue and working capital effects. It also reverses out the temporary payroll assistance payments from governments. On that basis, the Q2 cash burn for IAG came in at €28m ($31m) a day, somewhat lower than the average cash burn of $44m a day for the big 3 US Airlines. However, IAG is about 40% smaller than the US majors, so adjusting for size the figure is at the higher end of the range of US carriers.
I’d say that is quite an impressive performance by IAG to get close to the US carriers, given that it has a much smaller domestic market and international travel almost halted in the quarter. It has also had to bear the cash costs of the fuel hedging losses in the quarter (€6m/$7m a day), unlike the US carriers who don’t hedge.
Liquidity and raising more capital
But however good a job IAG did given the circumstances, reality makes no allowance for such factors and the truth is that IAG continues to burn cash very rapidly. Although the company revealed that it was targeting operating cash flow break even in the fourth quarter, that relies on travel markets reopening during the second half.
So perhaps it came as no surprise that IAG confirmed that it would raise up to €2.75 billion of additional capital through an underwritten rights issue. IAG's biggest shareholder, Qatar has already committed to support the capital raise.
I think that IAG would have preferred to wait until there was more certainty about the recovery before raising equity capital. But with net debt having risen by €3 billion already in the first half and the pandemic news from the US suggesting that a reopening of transatlantic routes may still be some time away, I guess they didn't have much choice.
When Willie walks out the door on September 8th, he will have done everything in his power to leave things in good shape for his successor, Luis Gallego. But it is clear that he also leaves plenty of challenges for Luis to tackle over the next few months.
I wish them both luck.
