IAG vows it will take legacy out of Iberia as losses deepen

7 August, 2012

International Airlines Group (IAG) is drafting a comprehensive restructuring plan for Iberia that will include short-term downsizing, network reshaping to deliver higher unit revenues and a re-evaluation of all aspects of the business. Job cuts will be an inevitable consequence of the overhaul. Efforts to address the Spanish carrier’s uncompetitive cost structure are not new and date from before the merger with British Airways (BA) in Jan-2011, but results have been insufficient and losses are spiraling out of control as the economic crisis in Spain worsens and the onslaught of LCCs persists.

While Iberia’s pilots continue to fight change other legacy carriers are restructuring and this is threatening Iberia’s leadership position in the Europe-Latin American market. The doubling of the departure taxes at Iberia’s main Madrid and Barcelona bases since 01-Jul-2012 is putting salt on the wound and diminishing the airline’s appeal.

Iberia accrued an operating loss of EUR263 million in the first six months of 2012 and this dragged IAG into the red for the period. As a group, IAG posted a EUR254 million operating deficit after exceptional items in 1H2012, a reversal of the EUR32 million profit that IAG reported in 1H2011 on a combined basis. BA remained in positive territory and recorded an operating profit of EUR13 million in 1H2012.

IAG’s net loss on a continuing basis for 1H2012 was EUR231 million, compared to a profit of EUR71 million on a combined basis and a EUR98 million profit on a consolidated basis in the year-ago period. The consolidated 2011 figure excludes 21 days of Iberia pre-merger while the combined figure includes these days facilitating a year-over-year comparison.  

IAG financial highlights: 1H2012 vs 1H2011*

Fuel costs wipe out strong 2Q passenger performance for IAG

The Group’s operating loss for the three months ending 30-Jun-2012 was EUR42 million but this narrowed to close to breakeven when not taking into account exceptional items that included a EUR36 million impact in restructure costs related to bmi, the UK airline IAG formally acquired from Lufthansa Group in Apr-2012 and which is being integrated into the BA mainline operation.

bmi trading losses and restructure costs have an approximate EUR90 million impact on 2Q2012. In a call with analysts presenting the 2Q2012 results, IAG CFO Enrique Dupuy pointed out that “when excluding bmi, IAG would have made a EUR46 million operating profit for 2Q2012 in spite of the extensive fuel bill hike and the Spanish headwinds”.

IAG realised a robust passenger revenue performance in 2Q2012, up 11.5%, driven by a good mix of premium and non-premium growth. Both volume and price contributed to the passenger traffic revenue increase but this was countered by an 11.9% rise in operating expenditure as fuel costs ballooned by 25%.

Mr Dupuy noted that the Group’s quarterly revenue and cost figures were “heavily inflated” in EUR terms because of the strength of the USD and the GBP. The impact of currency exchange rate changes contributed about half of the year-over-year 2Q2012 revenue growth. bmi added 2.1% to group revenues.

Unit passenger revenue in 2Q2012 rose 9.3% year-over-year on a reported basis and 3.6% on a like-for-like basis, which is pre-bmi acquisition and on a constant currency basis. CASK excluding fuel remained largely flat on a like-for-like basis but unit cost was up 11.9% on a reported basis owing to the strong rise of the cost of fuel and the strengthening of the dollar against last year’s references together with the growing deterioration of the Spanish trading environment.

IAG select financial and operating figures: 2Q2012 vs 2Q2011

The Spanish economy entered a recession in 3Q2008 and GDP contracted by 3.7% in 2009 and 0.1% 2010. It showed some signs of growth in 2011, but the country’s GDP slipped back into a negative growth in 4Q2011.

The International Monetary Fund (IMF) and the European Commission recently adjusted their forecast for Spain and now expect that Spain's GDP will shrink by 1.8% in 2012 and by 0.3% in 2013. Unemployment is 25% and climbing.

Spain GDP growth rate (annual % change)

 

 

1992-2007

3.1%

2008

0.9%

2009

-3.7%

2010

-0.1%

2011

0.7%

2012

-1.8%

2013

-0.3%

Long-haul RASK outperforms short and medium-haul

Mr Dupuy said that passenger unit revenue “once again” achieved a record figure in 2Q2012 on a like-for-like pre-bmi and constant currency basis and “this shows of IAG in the main strategic markets in which we operate, especially the Atlantic despite the weakness of the Iberian point-of-sale”.

IAG like-for-like* passenger revenue per ASK (EUR cents): 3Q2011 to 2Q2012

IAG’s performance on routes to/from to North America indeed showed a buoyant development with RASK growing 4.9% on top of a 4.6% capacity hike growth and IAG’s Latin American market recorded a substantial 7.5% unit revenue improvement on a capacity adjustment of 2.2%. Most of the capacity reduction on routes to/from Latin American was done by Iberia.

Unit revenue in the Middle East and South Asia market improved 6.8% year-over-year in 2Q2012 on a flat capacity while Asia Pacific routes saw a 1.8% increase in RASK on 5.5% capacity increase.

However, the picture is very different on short and medium-haul routes. IAG’s domestic network recorded a 3.4% decline in 2Q2012 in passenger unit revenue compared to the year-ago period on a 10% rise in ASKs, and this reflects the launch of Iberia’s fully owned LCC subsidiary Iberia Express on 25-Mar-2012. Iberia Express also has a markedly lower cost base and thus the year-on-year fall in domestic RASK is luckily on the basis of a lower CASK.

IAG CEO Willie Walsh told analysts that Iberia Express’ operating cost has been 10% better than expected and are 30% better than Iberia’s on a like-for like-basis. Madrid-based Iberia Express currently operates 10 A320s.

See related article: Iberia Express launches as Europe’s latest salvo to bring short-haul model to profitability

The European routes in IAG’s network operated with flat unit revenue on flat capacity and RASK was affected by the weakness in the premium segment. Mr Dupuy said that the underlying system wide unit revenue appeared “firm” in the group’s premium segment despite the soft demand for business class on short-haul routes and the anticipated distorted travel patterns caused by Olympic Games in London. “We still acknowledge a strong pattern in premium unit revenue figures,” Mr Dupuy said. The bulk of the premium growth in 2Q2012 and 1H2012 is on the British Airways side.

See related article: Olympic Games, despite conventional wisdom, present no large benefit to airlines

IAG passenger RASK and ASK growth (% change*) per region: 2Q2012 vs 2Q2011

BA turns a profit while Iberia sinks deeper into the red

IAG is increasingly becoming a tale of two companies with Iberia accounting for 27% of the Group’s external revenues but all of its operating losses. BA showed a significant year-over-year improvement in traffic figures and load factors in 1H2012 with unit revenue per ASK up 3.6%. In contrast, Iberia improved unit revenue in 1H2012 by only 2.1% on a capacity reduction of 5.2%.

Iberia’s RASK is lower than British Airways, while its CASK is markedly higher. The significant asymmetries in the performance of both companies through the first six months of 2012 is compounded by the diverging economic environments in which BA and Iberia operate. Spain is in a recession whereas BA’s home market is not. “Even though the UK’s economic figures remain weak, London is a different economy, and we’re not seeing any evidence of slowdown,” Mr Walsh said in the conference call with analysts on 03-Aug-2012.

The discrepancy between BA and Iberia’s performance was already evident in 2011, when the Spanish carrier accrued an operating loss of EUR98 million and BA an operating profit of EUR518 million. The airline has been trying to reduce costs and address the mounting losses on its short and medium-haul through the creation of Iberia Express, but efforts have been insufficient to turn the company around.

“The current economic conditions together with deeper signs and evidences of loss of competitiveness of the business model reinforce the need for deep and permanent structural changes in Iberia,” Mr Dupuy confirmed.

British Airways and Iberia performance: 1H2012 and year-over-year change

Iberia’s legacy costs and legacy operating conditions 'out of line'

IAG’s baseline assumption for its Spanish unit was for an operating loss in 2011 and an increased operating loss in 2012 but “the losses that we encountering exceed the target that we had planned for,” Mr Walsh admitted, noting that the competition is “clearly changing”. The Group had expected to see a relatively static or continuing strong competitive environment for Iberia but now believes that this is going to intensify.

Low-cost carriers remain very strong in Spain despite their recent announced capacity reductions. Their capacity share (% of total seats) at present amounts to 46% on domestic routes and 51% on international routes, according to OAG data.

In addition, competition on routes to Latin America is also on the rise and is threatening Iberia’s historic leadership position on the Europe to Latin America market, Mr Walsh said. IAG’s legacy counterparts in Europe are restructuring and both Air France and Lufthansa are adding capacity on routes to Latin America, while Latin American carriers are becoming strong competitors as they improve their business model and brand.

“Iberia’s short and medium-haul historically does not make money but they had a profitable long-haul. We do not think that the profits in the long-haul were sufficient to justify the long-term plan for growth,” Mr Walsh told analysts. “The main problem is the legacy cost base and the legacy operating conditions that are completely out of line with the market.”

IAG’s restructuring plan for Iberia will be much broader and deeper than former plans and every aspect of the business will be re-evaluated to deliver competitive costs and service to enable long-term profitable growth. 

The company aims to finalise the restructuring plan by the end of Sep-2012 and measures are likely to include short-term downsizing to reflect weakening economic environment and a reshaping of the network to deliver higher unit revenues on the long-haul. Iberia had planned for a re-branding in fall 2012 but this will be postponed to include features of the overhaul plan. Mr Walsh admitted that the Iberia brand is “old and a bit tired at this stage”. 

Iberia Express growth compromised by pilot resistance

Iberia’s new LCC subsidiary has been performing very well since it launched on 25-Mar-2012 and was profitable in its third full month of operation in Jun-2012 in spite of macroeconomic headwinds, Mr Walsh claimed. He also boasted that Iberia Express has established an “exemplary” operating performance from Madrid Barajas with an average on-time performance in excess of 95% and an operating cost base that was 10% lower than expected and 30% lower than Iberia on a like-for-like basis.

“The performance of both Vueling and Iberia Express demonstrate that it is possible to make money in the Spanish market despite all of the challenges there, but it is essential to have the right cost base and productivity and working conditions to do that,” Mr Walsh said.

Iberia Express had a difficult start with Iberia pilots represented by the powerful Sepla union calling several days of strike action in protest of the low-cost venture. Industrial action was halted as a government sponsored arbitration process was set in motion, but the outcome of the arbitration results are unsettling and could potentially endanger the LCC’s long-terms growth prospects. Mr Walsh told analyst that the “labour arbitration in its current form is very unclear and quite honestly we struggle to see how it can be implemented, and it [could] potentially put a cap on the cost competitiveness of the airline beyond the 14 aircraft that we will have accrued”.

The airline at present operates 10 aircraft to 15 destinations and its business plan envisioned 14 aircraft in 2013 and 40 aircraft by the end of 2015. Iberia Express has crew contracted for the growth aircraft in 2013 for a further four aircraft. According to Mr Walsh, the airline will probably exceed the 2013 financial target given the improvement in the operating costs. IAG expects Iberia Express to break even in 2012.

Extending these positive results to a larger part of Iberia’s heavily loss making short and medium-haul operations might not be in the cards if the outcome of the labour arbitration is upheld. Iberia appealed the arbitrator's decision in relation to the pilots’ union Sepla on 22-Jun-2012 on the basis that, among other reasons, the arbitrator went beyond his mandate and made a decision that will adversely affect management's ability to maintain an appropriate cost base for the business and that the decision will impede future growth prospects.

The court hearing is scheduled for 11-Oct-2012. Meanwhile Iberia and IAG management are looking into other possibilities to possibly complement Iberia’ Express’s operations if the court sides with the pilots union. Most of the LCC’s operations are within the European Union and these routes can legally be served by any airline holding a European Air Operator's Certificate (AOC); the airline does not have to be based in Spain or Madrid to operate from Spain. Most of Ryanair’s operations do not touch its home country Ireland.

IAG downgrades its full-year outlook and now expects a loss

IAG put a positive spin on its 2Q2012 results and said that a number of factors have improved over the three months through 30-Jun-2012. The underlying British Airways trading conditions remain firm and the bmi integration is on track, however, the bad news is outweighing the positive news and the Group has lowered its full-year guidance in light of the Iberian headwinds and euro zone instability.

The Group had previously targeted a breakeven operating result in 2012 after the impact of restructuring costs and the short-term earnings drag from the bmi acquisition. It now expects make a “small” operating loss in 2012. The Iberia restructuring plan could lead to further restructuring costs in the latter part of the year and widen the expected operating loss.