IAG CEO Luis Gallego Focussed On The Future

Like all airlines IAG reported a substantial loss for its financial year ended March 2022. The figure of €2.97 billion ($3.22 billion) represented an improvement over the previous year. As it moves into the peak summer period, there is cause for optimism in the outlook and the Group expects to be strongly profitable for the current financial year.

However, this must be measured against significant operational challenges that it faces in the near term and which have been playing out all too publicly as it wrestles with staff shortages and IT problems. It could also face post Brexit challenges to its ownership structure. CEO Luis Gallego has plenty to fill his in tray.

IAG-Last of the big European consolidation steps

When IAG, or to give it its full name International Consolidated Airlines Group, was founded in 2011, it was the last of the three big European network airline mergers. Air France KLM was the first, followed by a number of acquisitions by Lufthansa. The initial merger between British Airways and Iberia was not met enthusiastically by some as at the time Iberia’s financial and operational performance was poor. However, with IAG’s current CEO Luis Gallego at the helm, Iberia achieved a dramatic turnaround and the Group has gone on, in my view, to deliver leading performance amongst its peers both financially and in business and acquisition strategy.

Who is Luis Gallego?

Gallego has spent his career in the airline sector with extensive experience at a number of airlines in Spain. He won his spurs in IAG by successfully setting up a new low cost subsidiary, Iberia Express, to act as a short haul European point to point airline and to provide feed to Iberia. This success led to then IAG CEO Willie Walsh asking him to take the role in leading the turnaround of Iberia itself. The challenge was immense and engendered enormous sensitivity and careful engagement with Spanish unions. It was achieved without industrial relations carnage and Iberia has been transformed, delivering both profitability and sustainably improved customer service, a testament to Gallego’s acumen.

When Willie Walsh moved on in 2020, the IAG leadership baton was handed to him and it is he who must navigate through and beyond the covid pandemic whilst addressing other challenges including the Ukraine war, high fuel prices and rising inflationary pressures for consumers. Simultaneously, he must address the Group’s internal challenges and maintain the strategic focus on fleet developments and potential future acquisitions. Having met and talked with Gallego on a number of occasions, I believe that IAG has a leader of modest demeanour but with vast experience and a proven track record.

Consolidator

The rationale behind IAG’s establishment in 2011 was, beyond its initial British Airways and Iberia merger, to act as a consolidator in the European market. It subsequently added Aer Lingus, bmi (subsumed into British Airways) and Spanish low cost carrier Vueling to its portfolio as well as establishing a new long haul low cost airline Level.

It sees the opportunity for further consolidation and most recently had announced plans to buy Air Europa, a major player in the Spain-Latin American market. This acquisition would strengthen Iberia’s own position in that strategically important market, as well as bolstering more broadly its position in its Madrid hub. Madrid cannot currently compete with other European hubs such as Amsterdam or Frankfurt. It also makes no sense for IAG to attempt to run two Spanish hubs by developing Barcelona beyond its sizable point to point market, though it has a strong presence there via LCC Vueling, which can provide some feed to long haul Level services.

The pandemic led initially to a significant price cut in and postponement of the Air Europa deal and in late 2021 IAG announced that it would not go ahead in the planned form. However, the story is not over and IAG has now provided a seven year loan to Air Europa parent Globalia, the terms of which buy it more time and a one year period of exclusivity in exploring ways in which it might take a stake in the airline or continue with a takeover plan.

Now is not the time that IAG would wish to be exposed to additional capex but ultimately the deal still has strong logic in building up Madrid’s hub status. The Spanish Government also sees Air Europa as strategically important and without an IAG deal at some point, it is conceivable that it might not get back investment which it has made to keep the airline alive so it can be expected to be supportive.

However, despite other potential opportunities being around, I would not see other acquisitions as being likely given current markt conditions.

Finances

IAG has good liquidity but the pandemic has resulted in it taking on significant additional debt. It needs to be able to pay this down and markets are watching to see whether it might seek a further equity raise.

It also has to finance a substantial new aircraft order book. Some aircraft deliveries have been delayed but fleet upgrade and renewal is essential, especially as many older aircraft including BA’s large fleet of Boeing 747’s and Iberia’s Airbus A340’s were retired during the peak of the pandemic.

Aircraft fleet decisions

The long haul fleet is now pretty modern and efficient, centred around Airbus A350’s, Boeing 787’s and Boeing 777’s. BA has returned to service half of its 12 Airbus A380’s which are relatively young aircraft and well suited to a number of high demand markets. Many outstanding orders remain including for Boeing’s much delayed 777 X which is not likely to see service until 2025.

The short haul fleet across the group is built around the Airbus A320 family and increasingly the more efficient A320 and A321 NEO models. Of particular interest is what IAG will do with the MoU signed with Boeing for up to 200 737 Max aircraft, by Galego’s predecessor Willie Walsh. He was angered at delivery delays by Airbus and keen to show that IAG was not a captive customer.

Boeing needed a high profile blue chip customer win and no doubt the commercial terms are exceptionally advantageous for IAG. It is now evaluating the merits of fulfilling the MoU. It has to weigh up the additionl costs of operating both Airbus and Boeing aircraft in its short haul fleet. Competition amongst manufacturers is valuable to IAG and it certainly has the scale to justify a split operation.

IT failures

Inevitably given the challenging trading conditions, efforts are being made to cut capex but one area where it cannot afford to economise is IT investment. The largest airline in the group, British Airways, has been lambasted by media for several high profile IT failures in recent years which have brought it to its knees and angered customers.

The reality is that BA and other member airlines of IAG are no more or less exposed to IT failures than other long established airlines, all of which are too reliant on legacy systems. The same type of failures could just as easily beset its rivals. There are such a multitude of interlinked systems across the business that “IT failure” covers a multitude of sins.

The Group is well aware of the challenge it faces and in its year end results talks of “continuing to invest in key projects, including cyber-related investments”. It has set aside €600 million ($650 million) for such investments of which BA will be the largest beneficiary.

Such upgrades are complex and take time to deliver results. However, in my view and whilst acknowledging confidentiality and security sensitivities, IAG would nevertheless benefit from shedding more light on its plans both to build confidence that it is adequately tackling the issue and as a more assertive response to the regular criticisms it receives on this subject.

High Costs at Heathrow Airport

IAG has long had a prickly relationship with Heathrow when it comes to airport costs but the airport’s desire to hike charges by 50% to recover lost pandemic revenue is a significant challenge.

Heathrow’s CEO John Holland Kaye told me in an interview that in the airport’s view airlines were achieving stronger yields (average ticket revenues) than before the pandemic. Even if this is the case, it takes no account of the dramatically reduced capacity which airlines, including IAG, have operated from the airport over the last two years.

IAG, not surprisingly, has a different view. It acknowledges that while yields on some routes may be ok, load factors are considerably lower than pre pandemic. It also makes the point that transfer traffic, frequently price elastic, is indifferent as to which hub it uses. If one airport is much more expensive than another it undermines the economics and disincentivises an airline from using it as a transfer point. Added to this is the fact that long haul premium cabin business traffic, which is high margin and on which IAG depends, has far from recovered and further worsens the ratio between costs and revenues at Heathrow.

As this tussle plays out, there is not a risk that IAG and BA is about to move out of Heathrow any time soon, but it can juggle with capacity allocation and the management of transfer flows. Tariff increases by Heathrow could backfire were IAG to explore ways of maintaining its slot position but do so by deploying smaller capacity in some cases and focussing on more point to point traffic, thus having a negative impact on airport revenues. In the past, such a scenario may have appeared unlikely but in a changed market and faced with significantly escalated costs I believe it cannot be discounted.

Brexit Ownership Challenge

Another problem which Gallego may have to face is the post Brexit question of IAG’s ownership structure regarding airlines within the Group. Whilst IAG is an EU registered business, each individual airline has a national AOC (air operator certificate). IAG believes its ownership structure meets EU requirements whilst satisfying individual national regulators. There has nevertheless been speculation that competitors Air France KLM and Lufthansa may argue that British Airways is a non EU carrier and lobby to force a divestment by IAG. It would certainly be in their interest to do so.

British Airways is at the core of IAG’s profitability and there is no doubt that any such move would be fought strongly. At present there is nothing concrete to suggest it could happen.

Staff Challenges

Finally, turning to immediate challenges, as IAG ramps up to an expected 85% of 2019 capacity during the current financial year, it has been caught out by staff shortages and staff sickness. British Airways in particular has been in the spotlight for flight cancellations, delays and an overall less than satisfactory customer experience. This, contrary to media coverage, is not a problem unique to BA but pervasive in the industry. Individual airline CEO’s within IAG are accountable for the running of their businesses and BA boss Sean Doyle is only too painfully aware that the problems need to be fixed.

I do not buy that IAG cut too much at the start of the pandemic, they did what they had to do in order to survive and also recognised that the industry is going through significant structural change. As a group IAG needs to attract premium traffic, it underpins profitability and such customers are demanding, but it also needs to play in the high volume price sensitive markets dominated by LCC’s such as Wizzair, easyJet and Ryanair.

It may be a challenging summer but I am confident that under Gallego’s leadership it will recover its position as the leading European network group.