Is there less turbulence ahead for Aer Lingus?

Much of the news from Aer Lingus appears to be good these days. Shortly after its chief executive, Christoph Mueller, unveiled a new strategy with a renewed focus on long-haul, passenger figures gave an early indication that this could pay off while the company's interim figures show it is heading for profit this year.

But there is still plenty of scope for turbulence ahead, beginning with what is likely to be the latest chapter in the story of its fraught relationship with its chief rival: Ryanair is hanging doggedly on to its 29.8 per cent stake in the company after regulators shot down its third bid to buy it outright.

The UK Competition Commission is expected to demand that Ryanair sell the stake within the next three weeks. The watchdog spent 11 months investigating the impact the holding has on rivalry between the two on routes between Ireland and Britain and concluded that it commercially weakened Aer Lingus and could put others off bidding for the airline.

Donal O'Neill, aviation analyst with Goodbody, Aer Lingus's broker, suggests this could trigger the sale of the State's 25 per cent stake. The Minister for Public Expenditure, Brendan Howlin, said last year that the Government would do this under the right circumstances. Realistically, it is predicated on Ryanair exiting the shareholders' register.

Likely buyer
O'Neill says the most likely purchaser is Etihad, which has a relationship with Aer Lingus and already owns 3 per cent of the Irish carrier. Its chief executive, outspoken Australian James Hogan, has signalled several times that he would like to increase this holding.

“Etihad would love to take the Government’s stake,” O’Neill says. “It would take them up to 28 per cent, which is similar to what they have in Air Berlin and Air Seychelles.”

However, the middle eastern player is unlikely to do this while Ryanair holds onto its shares.

And Ryanair intends doing just that. Chief executive Michael O’Leary told analysts last month his company would appeal any ruling to sell its Aer Lingus stake to “every hill, ditch, mountains, stream and God knows wherever else, until we get to the European Court of Human Rights”.

Given that his company generally makes good on its threats to litigate, it could take years before it has exhausted all avenues. As a result, Aer Lingus has to proceed for the moment on the basis that Ryanair remains a shareholder.

David Holohan of Merrion Capital points out that Aer Lingus has managed to live with its rival's 29.8 per cent stake for over six years. During that time it has moved from a point where profitability was under pressure to one where it is beginning to grow.

"I don't think it will make a huge difference," he says of the likelihood that the situation will remain unchanged for the time being.

End to pensions row
O'Leary has recently taken to calling Aer Lingus a "pension deficit with wings". He's being colourful rather than accurate, but he is also pointing to something the market believes is potentially good news for the airline and its share price: proposals to end a long drawn out row over a shortfall in its workers' pension pot.

Staff at Aer Lingus and the Dublin Airport Authority are members of the Irish Aviation Superannuation Scheme, whose €780 million shortfall has several times brought both companies' workers close to striking.

In May, following six months of talks, the Labour Court recommended that the airline provide €110 million to a new fund, pay a number of salary increases due to staff this year and then freeze wages for a period. It is also being asked for €30 million for deferred beneficiaries.

The company has about €500 million in net cash, allowing it to easily cover the lump sum. While it does not have to seek shareholder approval for the move, it has already pledged to do so. Mueller is optimistic that the vote can go ahead in October and that the issue can be squared away by the end of the year. O’Leary says that the plan is a waste of shareholders’ money as the company has no legal liability for the deficit.

Ryanair will vote against the proposal but will be unable to block it on its own, as only a simple majority is needed to carry the day. The Government is likely to back the plan, meaning that Aer Lingus is half way home at least. Analysts suggest other shareholders will be swayed by a likely boost to the stock price if the deal gets across the line.

O’Neill agrees there is some merit in arguing that there are other uses to which shareholders’ cash could be put, but this is outweighed by the fact that a failure to draw a line under the pension row leaves the airline facing an ongoing threat of industrial unrest and uncertainty, with the consequence that the money could remain sitting on the balance sheet.

He points out that a deal means the company “starts at zero”, with no further pension liabilities, allowing it to look at reinvesting the cash and consider paying dividends to shareholders. As a result, he suggests, the stock’s performance should begin to improve to reflect these factors once that deal looks more like becoming a reality.

Holohan also believes a resolution will result in a positive re-rating for Aer Lingus shares. Both he and O’Neill point out that they are trading at a discount to those of many of its peers. The Merrion analyst calculates this at about 40 per cent, while his opposite number at Goodbody says the airline’s stock sells for about four times earnings, compared to an industry norm of five to six times.

Even if shareholders vote in favour of the pension proposal in the hope of unlocking some of this implied value, it should not be assumed that it is a done deal. The unions have to ballot their members and both the trustees and the regulator have yet to give it their blessing.

Shortly after the Labour Court produced the proposals, the trustees, chaired by Brian Duncan, expressed concerns about the provisions made for deferred beneficiaries. Then last month it emerged that the Pensions Board – the regulator – had written to the trustees saying it feared some elements did not comply with new rules governing retirement plans.

When the airline published its interims, Mueller hinted that the Pensions Board’s concerns could be addressed, but it is clear that there are still some hurdles to be negotiated before the whole question is finally resolved.

Against this background, the airline’s performance is improving. Last week it said long-haul passenger numbers were up 17 per cent in July, while a total of 1.025 million people flew short haul, 1.5 per cent more than in July 2012. Its operating margins are 5 per cent to 6 per cent. The company expects profits for the year to be €49 million, broadly in line with what it made in 2012.

Holohan says this compares favourably with other European flag carriers that are struggling to be profitable. He singles out long haul as the star performer, and says Aer Lingus is meeting some headwinds in its short-haul business, specifically in the competitive market on routes between Ireland and Britain.

In it for the long haul
The airline itself is betting on long haul to deliver growth and profits. Part of this strategy involves selling its services from Dublin to the US to British travellers as a viable alternative to going via Heathrow.

The logic is that if you are flying from a regional centre such as Manchester or Edinburgh, there is little difference in time, but in Dublin you avoid the hassle of Heathrow and get visa clearance at the same time.

Aer Lingus articulated the strategy in June, but it looks set to suffer a minor setback next week. Pilots at Aer Arann, which operates Aer Lingus's regional services, including flights from Britain to Dublin, and which has embraced the plan, are threatening to strike next week in a row over pay. Their employer responded to this by saying it would have to consider putting staff on protective notice.

While the strike is timed to start on Tuesday, talks began in earnest last night to resolve the dispute and avoid travel chaos.

If the action does go ahead, Aer Lingus will lose business and potentially see its reputation damaged, as its services are threatened with cancellation. O’Neill says the smaller partner has only been providing about 35,000 to 40,000 of its connecting passengers to date, about 4 per cent of its entire long-haul business.

While he does believe the Aer Arann service could become an important element of the larger partner’s long-haul strategy over the medium term, he does not see the strike threat as a major blow at this point. In terms of the strategy itself, he says it has a lot of potential: “There is a quite a bit of upside to come from it if they can get it right.”