Paul Hill, one of Britain’s most successful private investors, picks the worst share tip from the week’s press and broker’s reports. This week, a company whose shares have been soaring of late, but could be about to nosedive.
Turkey of the Week: British Airways (BAY, 436p), tipped as a BUY by The Times
British Airways shares have been soaring over the past two years, despite some strong headwinds. The share price has doubled, in spite of sky-high oil prices, a widening pension deficit (£2.1bn) and terrorist attacks. So what’s behind this stratospheric increase?
The Times rightly pointed out last week that fuel costs have fallen by about 20% since their summer peak, while BA’s more profitable business-class service continues to perform well. And the shares, even after their recent lift-off, are still only trading on a current year p/e ratio of 10.5 – not too expensive, compared to the rest of the market. Operational performance has also improved, due mainly to better cost control and fuller flights.
These factors have undoubtedly helped in turning the business around and driving up operating profit (EBIT) margins from 5.4% in 2004 to 8.5% this year. Now the management team has set its sights on achieving margins of 10% by 2008, which might well be feasible. But broker estimates assume this level of profitability is sustainable in the long term, whereas I’m much more sceptical. Let me explain why.
Other than fuel (representing 20% of total expenditure), the majority of an airline’s costs, such as aircraft and employees, are fixed. Simply put, this means when the market is buoyant, as it is today, the higher sales generate bumper profits. For example, sales of business and first-class tickets have been going gangbusters – partly as a result of mergers and acquisitions – as executives and financiers fly to conclude corporate deals.
But shareholders should beware – this is a notoriously cyclical industry. When the economy slows, people and companies start cutting unnecessary expenses and premium-rate travel goes into a tailspin.
So when valuing a business such as BA, it is crucial to look across the entire economic cycle in all its phases. Over the past seven years, BA has generated average EBIT margins of 4.5%. So how are 10% margins going to be sustainable in the long term, as the City believes?
This seems particularly unlikely in light of intense competition from low-cost rivals, plus its heavy reliance on premium-rate traffic (22% of profits) and the possibility that it will be forced to sell some of its valuable landing slots under new proposals being discussed with the US.
A further problem is that the huge pension deficit could ignite industrial action as management attempt to cut staff benefits. Until this issue is resolved, BA cannot press on with a multi-billion-pound fleet replacement programme, nor resume dividend payments to shareholders.
To cap it all, BA said on Monday that two of its directors had resigned following investigations into alleged price fixing. If the firm is found guilty by the Office of Fair Trading or the US Department of Justice, then shareholders can expect hefty fines – up to 10% (£700m) of turnover – and also damage to BA’s brand.
Let’s assume, for argument’s sake, that average margins of 7% are achievable. This would generate underlying EPS of around 34p for this year, as opposed to the 41.5p presently forecast – putting the shares on a p/e of 12.6 times. At this level and with all of its potential problems, BA’s shares are currently overvalued and best avoided, especially given any sign of economic weakness.
Recommendation: TAKE PROFITS at 436p