Turkey of the week: worthless airline driven by speculation

By Paul Hill Sep 04, 2009

Paul Hill

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British Airways' shares have soared over the past two months, despite high oil prices, an estimated £2.5bn pension deficit, £2.4bn net debt and the "harshest trading environment we have ever faced". Why is this? Speculation, speculation and speculation. Based on fundamentals, and in the absence of any dividend support, my view is that the equity is worthless.

Sure, chief executive Willie Walsh is doing a good job of slashing overheads, even appealing to staff to work for free. But given the depth of the aviation crisis, the drop-off in business travellers and British Airways' cost disadvantage compared with the likes of Ryanair, working for a few weeks without pay is tokenism.

The group is losing about £1m a day and its ageing fleet (its average aircraft is 12 years old) is less efficient in terms of fuel use and maintenance than its more nimble peers. The industry also faces long-term overcapacity, cut-throat competition, subsidised flag-carriers, rising taxes on flights, the development of high-speed rail and the threat from terrorism and infectious diseases such as swine flu.

British Airways (LSE: BAY), tipped as a BUY by Astaire Securities

When valuing a cyclical business such as BA, it's crucial to look at sustainable returns through both thick and thin. Assuming a 'through-cycle' operating profit (Ebita) margin of 5% (compared to estimates of -2.5% and -4.5% for this year and next) on turnover of £8bn, and overlaying an eight times multiple, one generates an enterprise value of £3.2bn (5% of £8bn times eight).

So after deducting the debt pile and adjusting for retirement obligations, I estimate that British Airways' equity is worth zilch. Of course, there's always a small option value left in the shares, reflecting the off-chance that somebody may wish to buy the airline's landing slots at Heathrow and Gatwick. But I'm sure the pension black-hole will deter even the wealthiest bidders. The trouble is that if someone wanted to take the firm over, the trustees would almost certainly insist on a large cash injection (perhaps up to £2bn) for the deal to be approved.

Finally, the group looks set to keep burning cash for the foreseeable future.If this doesn't stop soon, British Airways' lenders could force it into a deeply discounted rights issue. Time to bail out.

Recommendation: SELL at £1.82

• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

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