Is International Consolidated Airlines heading for a crash landing?

Almost exactly one year ago, I asked whether I should buy British Airways owner International Consolidated Airlines (IAG) for the SIF portfolio. Remarkably, one year later IAG has popped up in my stock screen again.

Last year, I decided not to add to the stock to the portfolio. Coming just a few days before the EU referendum, this decision has helped me avoid a loss. The shares slumped after the Brexit vote and didn’t start to recover until late October. Had I sold in December after six months, in line with last year’s portfolio rules, I’d have logged a 10% loss.

However, IAG’s recovery has continued and the shares are now worth more than 600p. That’s about 20% more than when I last looked at the stock a year ago. Remarkably, the firm’s recent IT fiasco hasn’t dented the share price. Perhaps this is because the rumoured £80m cost of the IT failure is peanuts to a company of this size.

Or perhaps investors believe that British Airways has a sufficiently entrenched position to hang onto its customers, however badly it treats them. Any underlying issues facing the firm’s brands have yet to hit sales, so the market may be ignoring this risk.

Luckily, my job here is not to try and judge IAG’s operational performance. It’s to assess the firm’s financial profile and decide whether I should add the stock to my rules-based Stock in Focus portfolio.

Not straightforward

This FTSE 100 group currently has a StockRank of 98 and a StockRank Style of Super Stock. Stocks with these characteristics have historically tended to outperform the market, although there’s no guarantee this will continue.

This stock also qualifies for nine of the long Guru Screens which model the investing strategies of famous investors. Several of these screens have delivered annualised returns of more than 20% since they started running on this website. The only fly in the ointment is that IAG also qualifies for two short-selling screens. Should this be a concern?

In the remainder of this piece I’m going to look at the bull case for the stock and investigate why IAG qualifies for these short-selling screens. Should I steer clear of the stock, or is it a buy for the SIF Portfolio?

It’s still cheap

Rigorous cost management, rising passenger numbers and a well-timed oil market crash have made airlines more profitable than they have been for years. IAG is no exception.

Sales have risen by 21% to €22,567m since 2013. But the group’s underlying net profit has risen by 362% over the same period, from €430m to €1,900m. Looked at a different way, IAG’s underlying operating margin has risen from 4.1% to 11.2% since 2013.

Despite this, the market has been reluctant to reward the firm’s success with a high valuation. IAG has a trailing P/E of 7.9 and an impressive earnings yield of 14.7%. These factors have helped the stock earn a ValueRank of 86.

One potential concern is that free cash flow has been negative every year since 2011:

Stockopedia figures are calculated by Thomson Reuters from IAG’s accounts. But the airline reported free cash flow to equity of €2,055m last year, up from €1,481m in 2015. How can this be?

The difference is down to cash pension contributions, restructuring costs, provisions and movements in working capital. IAG excludes these from its FCF calculations, but they resulted in a net cash outflow of €660m in 2016 and of €1,215m in 2015:

IAG has an actuarial pension deficit of €4.7bn and has committed to deficit reduction payments of €4bn over the next 10 years. In my view these aren’t really exceptional costs and should be included in free cash flow calculations.

Mixed quality?

The stock’s QualityRank of 78 is fairly high. But if you look at the components of this score (click here then click on the rank numbers) you’ll see that the only real highlight is the Piotroski F-Score of 9/9. This fundamental health score is weighted heavily in the QualityRank algorithm, thanks to the broad range of factors it covers:

IAG’s weak historic profitability means that many other quality factors are less impressive. The group’s five-year average return on capital employed (ROCE) is only 6.5%, while its five-year average net margin is just 3.3%. I believe this stock has some way to go to prove itself as a good long-term investment.

Flying momentum

IAG’s MomentumRank is strong, at 87. Both price momentum and earnings upgrade factors appear to provide support for further gains:

The share price is within a whisper of its 52-week high and relative strength is also positive. First-quarter performance was strong, with adjusted operating profit up by 10% to €170m. This prompted a round of broker upgrades:

These rising earnings forecasts could encourage buyers, given that the stock now trades on a forecast P/E of 7.2, with a forecast yield of almost 4%.

Should I short IAG?

To be clear, I’m not short IAG and I’m not suggesting anyone else should be either. However, the firm’s appearance in two short-selling screens cannot be ignored. So let’s take a closer look.

Altman Z-Score screen: The Z-Score uses several balance sheet ratios to assess the likelihood of a company becoming financially distressed. IAG scores poorly with a score of 1.23, below the 1.8 threshold above which a company is considered in good health. However, more than 200 companies currently qualify for this screen, including names such as GlaxoSmithKline, National Grid and Rolls-Royce. I’m not sure it’s of much immediate value to us on its own.

James Montier Trinity of Risk screen: This is more interesting, in my opinion. Only eight companies currently qualify, and IAG is the only big cap. The rules specify three ratios:

These rules correspond to three risks: excessive valuation, unsustainable earnings and financial distress. The logic seems to be that a sharp rise in earnings or valuation is often unsustainable, especially when it’s combined with warning flags for financial distress.

My verdict

So is IAG a house of cards that’s about to collapse? My view is that the inclusion of the firm in these two short screens is a result of two factors. The first is the chain of acquisitions which have accelerated IAG’s growth since 2011.

The second factor is that this cyclical industry is enjoying serious tailwinds from passenger growth and falling costs. At some point, I expect one or both of these tailwinds to reverse. But that could be several years away yet.

In my view, it’s probably too soon to bet against airlines. So with fingers crossed and some misgivings, I’m going to add IAG to the SIF Portfolio this week. As always, please let me know what you think in the comments below.