El Al flying towards financial turbulence

Dreamliner

Despite shrinking equity, growing competition, and high fuel prices El Al insists it will soon return to profitability. Avishai Ovadia is not so sure.

The loss posted by El Al Israel Airlines Ltd. (TASE: ELAL) is not the most important figure in the company's financial statements for 2018. In my opinion, El Al's 3,570 employees at the end of the year, 10 fewer than a year earlier, are more important.

The number of El Al's temporary workers declined more substantially - from 2,742 to 2,608. These numbers can be misleading, however, because the number varies, mainly according to season. Even if we assume that El Al is cutting back its staff, however, which is by no means certain, the dismissed employees are primarily temporary ones. That is far from enough for a company in jeopardy.

El Al reported a $52.2 million loss for 2018, compared with a $5.7 million profit in 2017. The company's large-scale red ink contrasts with its 2% increase to $2.14 billion in revenue.

The loss eroded El Al's equity to $228.6 million. This amount sounds impressive, but not when its loss amounts to a quarter of it, especially since El Al's real loss is over one quarter, and not when its balance sheet total exceeds $2.1 billion. In this situation, El Al's equity does not provide a substantial margin of safety. Furthermore, the company's accounting equity is not a solid as you might believe.

Competition will intensify in 2018. What will happen to El Al's bottom line?

The real reason for El Al's loss is its continually diminishing profit margin. The company's 2018 gross profit was $282.2 million, 13.2% of turnover, compared with $348.3 million, 16.6% of turnover, in 2017. This decline is a result of greater competition: "Competition has intensified in recent years," El Al's management explains in the company's report, adding, "The increase in competition in recent years pushed ticket prices down and increased passenger traffic. Among other things, intensifying competition is reflected in expansion in the range of destinations and the frequencies of the airline's flights."

El Al's activity increased, which is probably why the company retained its staff of tenured workers, despite lower prices and profits. That is what happened last year, but what is in store for the coming year? El Al says, "The company believes that competition will further intensify in 2019."

So El Al lost $52.2 million because of competition, which will increase in 2019. The obvious conclusion is that the company will also lose money in 2019, although there are of course other factors affecting El Al's volume of activity, financial statements and profit.

El Al is very sensitive to changes in oil prices, which rose in recent months, indicating the jet fuel prices are likely to rise. In the company's report, its managers stress, "As of the report date, the market price of jet fuel, excluding fees and suppliers' margins, weighted according to the markets in which El Al buys jet fuel, was $1.615 per gallon, while the price close to the date on which the reports were approved was $1.95 per gallon, a 21% increase. Note that spending on jet fuel accounts for 24% of the company's revenue turnover, and changes in the price of fuel have a substantial effect on the company's financial results."

So not only will competition intensify in 2019, but raw material prices will rise. There are not all of the factors affecting El Al's results and profits, but the starting point for 2019 appears shaky.

El Al believes it will make a profit in the coming years, but is this likely?

If El Al is on shaky ground, why does the company insist on telling us that it will make a profit in the future?

El Al posted $15.6 million in tax revenue in its 2018 reports. Without this revenue, its loss would have been $67.8 million. This revenue comes from two items: a $12.4 million tax expense for deferred taxes - an accounting expense for the benefit received by the company, and $28.4 million in tax revenue. This revenue is from the company's current losses, and can be counted only if the company expects future profits.

It works like this: El Al loses money in a given year, but expects profits later. It can claim that reporting the loss without tax revenue detracts from its true reporting, because just as if it had a profit, it would have paid tax that would have reduced its profit, a loss creates an asset - a loss for tax purposes. This asset can be used in the event of future profits. The chances of profits, however, can already be assessed now, and if there is a reasonable chance of profits, this asset can be reported in the books. The asset offsets the loss, and El Al therefore reported tax revenue.

This asset is nothing new. El Al regularly treats its losses as temporary. The company has $387 million in accumulated tax losses, but believes that these losses will turn into future profits. This confidence led the company's management to report a tax asset for this entire amount. This asset, which is a saving on payment of tax on up to $387 million in future profits, amounts to $89 million (23% tax on $387 million in future profits).

This asset is not a sure thing. Given El Al's 2018 results and what lies ahead in 2019, it may be overestimated. If this is the case, then El Al's relatively low $228 million equity is even lower in absolute terms.

From a conservative perspective, an important question arises. Given El Al's losses, the competition, the increase in the price of jet fuel, its questionable tax asset, and its flimsy equity, is El Al a going concern? This is a business or economic question of accounting significance. A business that does not make sustained profit, while its equity is being eroded, while at the same time, its financial ratios show weakness, and even distress, cannot achieve its purpose - creating value for its shareholder. In many cases, it is also unable to service its debt. El Al may not have reached this point, according to its accountants, who have refrained from listing a going concern warning, but the company is definitely in financial jeopardy.

The author is a lecturer in accounting, financial statement analysis, and valuations, and a consultant in these areas. In any case, these reports should not be regarded as advice and/or a recommendation to buy or sell any security. Anyone whose actions are based on the article and/or on its content bears the exclusive responsibility for any damage and/or loss caused to him.

Published by Globes, Israel business news - en.globes.co.il - on March 17, 2019

© Copyright of Globes Publisher Itonut (1983) Ltd. 2019

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