British Airways owner International Consolidated Group PLC (LON:IAG) shares flew higher on Wednesday after JP Morgan initiated coverage of the stock with an ‘overweight’ rating.
Shares in IAG, which also owns Vueling and Aer Lingus, have fallen 38% below a high in June 2018 but JP Morgan believes many investor concerns are overdone.
READ: IAG passenger revenues dip but 'not due to Brexit'
“We also believe investors are overlooking IAG’s attractions: high pre-tax profit margins (on par with Ryanair); a diversified portfolio that should mean more resilient earnings than in the past; strong market positions; a strong balance sheet; and rising cash returns to shareholders,” JP Morgan said, giving the stock a target price of €8.35, suggesting 60% potential upside.
“We cannot rule out near-term downside, mainly due to Brexit uncertainty, but we believe IAG has robust long-term prospects and is significantly undervalued.”
The investment bank said some investors think IAG’s earnings will evaporate in a recession as happened to individual airlines within the group in the past. But JP Morgan does not think this will be the case.
'Materially mispriced' against Ryanair and easyJet
It believes IAG is "materially mispriced" against Ryanair and easyJet.
“IAG’s earnings before interest and tax (EBIT) margin and return on capital employed are now as good as Ryanair and much better than those of easyJet.
“But relative to these two low cost carriers, IAG is trading on c55-65% price-earnings discount and a circa 30-45% enterprise value/EBIT discount.”
Hard Brexit would be 'challenging'
However, JP Morgan admits a hard Brexit would be “challenging”. UK shareholders would likely lose voting rights and may be forced to sell their shares. If the pound fell 10% against the US dollar and the euro, it could take 20% of earnings per share due to transaction and translation impacts, the bank said.
Another concern is pay talks with British Airways unions. This year the airlines three major unions have all demanded a 5% pay increase and a profit-sharing scheme. British Airways typically offers a 3% pay rise.
JP Morgan said if the airline’s wage bill was 2% higher than planned, it would equate to €57mln, or 1.6% of IAG’s EBIT so is not a major concern.
The bank added that even if British Airways agreed to a profit share scheme of 10%, which is highly doubtful, it thinks the current valuation of IAG more than discounts such risk.
JP Morgan says M&A unlikely in near future
On investor fears about IAG making an overpriced acquisition, JP Morgan sees little prospect that the group can undertake a meaningful deal any time soon.
IAG expects average net capital expenditure of £2.6bn per year from 2019-23 as it refreshes its fleet, compared to an average of £1.7bn from 2014 to 2018.
“We still expect IAG to generate solid annual free cash flow over the coming five years,” JP Morgan said.
Around noon shares in IAG were up 2% to 472p.