“Being in the most comfortable deckchair on the Titanic was still not a good place to be,” the chief executive of British Airways, Rod Eddington, said last month. “To relax would be fatal, absolutely fatal.”
The phrasing may be dramatic, but it reflects the necessary caution of a man who has overseen near disaster and a tentative turnround at the “world’s favourite airline”, as BA likes to call itself.
BA was the most profitable airline in the world nine years ago. But by 2000 it had slipped to 21st position as operating profits fell 88 per cent. Weighed down by huge debt, a burgeoning pension deficit, and facing relentless competition from the new low-cost carriers such as EasyJet and Ryanair, BA began to be unkindly referred to as a hedge fund that happened to own a few aircraft.
Eddington, who took over as chief executive insince May 2000, acknowledged that “BA has no God-given right to survive”. But the Australian, chief executive, who will leave his post this autumn, has made great strides in addressing BA’s problems. Since 2000 BA’s net debt has been halved from its peak of £6.6bn, and costs have been reduced dramatically. Passenger volumes are at record highs and, despite wildcat strikes and a great deal of union grumbling, a wage agreement was reached last August. Last year BA reassumed the mantle of most profitable airline in the world (even if measured by absolute operating profits and not profit margins).
But at 275p, the share price is still way below its 10-year high of more than 700p in 1997, and 445p in January 2002. The shares have underperformed both the market as a whole and the transport sector since 1997, yet analysts were bullish this time last year, and are still bullish now.
From an outsider’s point of view, their positive attitude may seem surprising. The global airline industry is in crisis, with few airlines making a return on capital that is greater than their cost of capital. What this means is that, over the long term, they cannot make a sustainable profit.
After makingincurring a pre-tax loss in 2002, BA returned to a £165m pre-tax profit in 2003, on turnover of £7.69bn. Last year turnover fell to £7.56bn, but pre-tax profit rose to £282m. But tTo return to long-term profitability, BA must improve its operating margin (its operating income expressed as a percentage of its net sales), currently just above 5 per cent. BA staff have been given an incentive of one week’s pay or £500, whichever is the higher, when operating margins reach 6 per cent. Analysts believe margins are likely to reach this goal 6 per cent this year, but this is still a long way off the target which has beenset by management of 10 per cent.
To achieve further improvement, in margins,Willie Walsh, the former boss of Aer Lingus who takes over as chief executive in September, will have to cut costs further. This is only one of many challenges. he the new chief executive will face. The pension fund deficit – which was estimated at £928m in March 2003 – remains a nagging toothache, and BA is also having to deal with thesharp increases in the price of oil. which is hovering close to $60 a barrel.
This time last year, when the shares were trading at 330p, analysts were overwhelmingly positive about the stock’s prospects. One year on, the share price is lower, than it was then, yet analysts are still bullish.
Stephen Furlong , airline equityanalystat Davy believes the issue of the pension deficit has receded in importance. “The pension deficit is still a serious issue,” he says. “But it has been known by the market for so long.
“BA looks to us to be one of the most attractive airline in-vestments. Only 10 per cent of its business is exposed to low-cost carriers; Terminal 5 at Heathrow will bring world-class connecting facilities; there are £300m in employee cost savings to come; further cost-cutting is likely under CEO designate Willie Walsh; and the free cash flow story is strong.”
Anthony Bor analyst at Merrill Lynch also has the stock on a buy recommendation. “The stock can justifiably be viewed as a potential cyclical recovery play in an industry where success in cost reduction is increasingly becoming a differentiating factor,” he argues. “Management acknowledges commercial reality and is already well down the road in preparing for the risk of any further structural weaknesses to the industry revenue environment.”
“We believe British A irwaysoffers a very attractive early-cycle cash return for those investors prepared to take on the current political and fuel price risks associated with the travel sector,” agrees Andrew Light , analyst at Citigroup Smith Barney. “We expect BA to resume paying dividends within one year.”
Analysts believe British Airways shares will rise. But they were similarly bullish this time last year when the shares were trading around 20 per cent higher.
BA has room to beef up profits through a further wave of cost-cutting. But investors should not forget that BA will continue to face the risks confronting all airlines – cyclicality, overcapacity, fuel prices, labour strength, terrorism and the sensitivity of travel demand to external shocks such as a resurgence of Sars.
