Description

Investment Thesis

Air Canada stock is a compelling long investment opportunity with >50% upside potential from current levels.  Not only is there a significant valuation disconnect between it and other carriers (trading at 3.3x EV/2015E EBITDA vs. US-based carriers at 5.1x EV/2015E EBITDA, a 35% discount) which provides an sizeable "margin of safety", but also there are many fundamental factors which make the Air Canada story quite attractive.  These include: (i) market share leadership, (ii) corporate transformation through new labor agreements which provides for both revenue growth and margin expansion, (iii) operational improvement through the introduction of new aircraft, (iv) cost savings through a revised capacity purchase agreement with a regional carrier and (v) balance sheet improvement.  Further, although airlines have been a popular sector for investors during 2013 and 2014, Air Canada is a significantly "less followed" company both from the buy-side and sell-side; it's not as well known to investors and only recently has become sizeable enough in terms of both market capitalization and trading liquidity for larger institutions to take interest.  Accordingly, there should be a significant amount of capital from "marginal buyers" that can flow into Air Canada's stock and drive its price upward as its fundamentals play out.

Company Description

Air Canada is Canada’s largest domestic, U.S. transborder and international airline and the largest provider of scheduled passenger services in the Canadian market, the Canada-U.S transborder market and in the international market to and from Canada.  The Company is one of the 20 largest airlines in the world and is a member of the Star Alliance.  In 2013 Air Canada, together with Jazz and other collaborating regional airlines, operated, on average, 1,498 scheduled daily flights to 181 direct destinations on five continents, comprised of 60 Canadian cities, 54 destinations in the United States, and a total of 67 cities in Europe, the Middle East, Asia, Australia, the Caribbean, Mexico and South America.

Passenger revenue by geographic region for 2013 was:

·         Canada – 38%

·         U.S. Transborder – 20%

·         Atlantic – 20%

·         Pacific – 15%

·         Other – 7%

Fundamental Analysis

Many factors make the fundamental outlook for Air Canada positive.  These include:

·         Market Share Leader –Air Canada holds a 55% market share of the domestic Canadian market, well ahead of its closest competitor WestJet’s with a 35% market share.  In the U.S. transborder market, Air Canada also has the largest market share of 35% vs. its competitors WestJet with 19% and United with 17%.  Further, Air Canada has 37% of the market of non-U.S. international travel to and from Canada.  Air Canada’s dominant market position provides the Company with a greater degree of pricing power than that of US carriers where the market is more fragmented and the landscape more competitive.  Further, Air Canada’s market share leadership enables it to be the preferred service provider to business travelers which tend to be higher margin customers (on 9/23/14 the Company issued a press release noting that in an Ipsos Reid survey it was selected as the preferred airline by 83% of Canadian frequent business travelers for 2014).

·         Corporate Transformation through New Labor Agreements, Providing Both Revenue Growth and Margin Expansion - One of the most critical elements of the Air Canada investment thesis is the corporate transformation efforts management has been executing over the past two years, made possible through the revision of labor agreements.  History is important here.  Legacy Air Canada had always been unable to economically provide service to the leisure market due to its higher cost operating structure, principally stemming from labor costs and operating restrictions.  Under new labor agreements, Air Canada has been undergoing a transformation to now serve the leisure market, enabling Air Canada to expand its operations, driving revenue growth, and expand its margins.  Of note, on the recent 3Q14 earnings call, management commented that they remain on track to achieve a 15% CASM reduction over the next few years vs. a 2012 baseline.  This is a very sizeable reduction in costs.  The main elements of the transformation are:

o    New Collective Labor Agreement with the Air Canada Pilots Association through 2016 –  After 19 months of extremely bitter negotiations, Air Canada received in June 2012 a favorable ruling from a federal arbitrator for a new collective labor agreement with the Air Canada Pilots Association.  More than anything, this new agreement enabled Air Canada management to change the cost structure of the airline.  The new agreement improved Air Canada’s competitive position by allowing more flexibility in its relationship with regional airlines and in the composition of the mainline fleet.  Specifically, the new collective agreement allowed Air Canada to conduct business with multiple regional partners whereas in the past it was limited in this regard.  Further, the new agreement provided the Company with the ability to operate a new low-cost airline named Air Canada rouge. Of note, the new labor agreement only extended through 2016.  The agreement's short duration served as a contributor to Air Canada's discounted stock valuation as investors were concerned that the inevitable contract renewal process would again be highly confrontational and disruptive to the Company's operations.

o    Launch of Air Canada rouge – Air Canada rouge launched its operations on July 1, 2013.  The new, low-cost carrier has been providing Air Canada with a sizeable avenue for growth through greater penetration of the leisure market.  Further, through Air Canada rouge and its lower cost operating structure, Air Canada has been enhancing its margins on leisure routes previously operated by its mainline as well as pursuing opportunities in international leisure markets.  Air Canada rouge's lower cost structure is driven by the increased seat density of its aircraft, lower wage rates, more competitive work rules in labor agreements and by reduced overhead costs.

o    New Collective Labor Agreement with the Air Canada Pilots Association through 2024 – On October 31, 2014 Air Canada announced that it had reached a new, 10-year collective labor agreement with the Air Canada Pilots Association through 2024.  The ratification of the agreement was a major achievement for Air Canada because it provides the Company with greater stability and long-term cost certainty.  Further, the fact that the agreement was reached (i) two years ahead of schedule and (ii) in a non-confrontational manner (84% of pilots voted for the contract with 92% taking part in the vote), is indicative that the relationship between Air Canada and its pilot union has greatly improved.  The sharp reduction in the risk profile of Air Canada's labor situation should warrant a commensurate reduction in the valuation discount at which it trades.

o    Positioning of Toronto Pearson Airport as a Preferred North American Hub – Related to Air Canada's increased ability to target new markets and expand its operations due to the revised labor agreements, the Company has also been active in its pursuit of making Toronto Pearson airport the preferred international travel connecting hub for North American flights.  On October 18, 2013 the Company announced a new commercial agreement with the Greater Toronto Airports Authority to further develop Toronto Pearson as a global hub.  Air Canada is seeking to position Toronto as a more convenient, traveler-friendly, and viable alternative to US hubs.  Currently, US visa requirements mandate that all passengers entering the US must pass through immigration regardless of whether or not they are connecting to other US flights.  For example, a passenger travelling from Paris, connecting through New York, and continuing to Mexico City, must collect their baggage in New York, pass through immigration, re-check their baggage, and pass through security again to board their flight to Mexico City.  By flying through Toronto, passengers can avoid this inconvenience and source of significant delay.

·         Operational Improvement through the Introduction of New Aircraft – Air Canada expects to improve its operations through the introduction of new aircraft.

o    Introduction of High-Density Boeing 777 Aircraft – In 2013 and early 2014 Air Canada took delivery of five high-density Boeing 777s.  These aircraft offer a new three-cabin configuration comprised of International Business Class, Premium Economy Class and Economy Class and are being deployed on select markets where there is a higher demand for economy travel. Air Canada has estimated that the new Boeing 777 aircraft, with its higher seat density configuration (458 seats), has a 21% lower CASM than the 349-seat Boeing 777 aircraft in Air Canada’s current operating fleet.

o    Introduction of Fuel-Efficient Boeing 787 Aircraft – Air Canada took delivery of six Boeing 787 aircraft in 2014 and is scheduled to take delivery of 31 aircraft between 2015 and 2019.  The Boeing 787 will operate existing routes currently operated by Boeing 767 aircraft and will also permit the airline to pursue new international growth opportunities in a more efficient manner.  The introduction of these aircraft into the mainline fleet will allow the airline to reduce operating expenses through fuel and maintenance savings.  Air Canada has estimated that the fuel and maintenance efficiencies associated with the Dreamliner, combined with a greater number of seats, will allow for a much better unit cost performance – 29% below that of the Boeing 767 aircraft it will replace.

o    Narrow-Body Fleet Renewal Program – In December 2013 Air Canada announced an agreement to purchase up to 109 Boeing 737 MAX narrow-body aircraft. The new aircraft will replace Air Canada’s existing mainline fleet of Airbus narrow-body aircraft, creating one of the world’s youngest, most fuel efficient and simplified airline fleets.  Deliveries are scheduled to begin in 2017 with two aircraft, and with the remaining deliveries between 2018 and 2021. Air Canada has estimated that the projected fuel burn and maintenance cost savings on a per seat basis of greater than 20% will generate an estimated CASM reduction of approximately 10% as compared to the airline’s existing narrow-body fleet.

o    10-for-20 Replacement Program - As part of the Boeing 737 MAX order described above, Boeing has agreed to purchase 20 Embraer aircraft from Air Canada.  These 20 aircraft will be replaced with five Airbus narrow-body planes which Air Canada has sourced from third parties, as well as five Boeing 767 aircraft which will remain in the fleet rather than being returned to lessors as originally planned.  This 10-for-20 replacement program is expected to drive a CASM reduction of 10% versus Air Canada's current unit costs for related flying.

·         Cost Savings through a Revised Capacity Purchase Agreement - On February 2, 2015 Air Canada announced that it finalized a revised capacity purchase agreement (CPA) with Chorus Aviation, the parent company of Jazz Aviation.  Jazz Aviation is a regional carrier which operates flights on Air Canada's behalf.  The new 11-year agreement increases Air Canada's competitiveness in regional markets through lower unit costs and improved pricing.  Air Canada management expects the revised agreement to generate ~C$550 million in financial value over the next six years, two-thirds of which will come from network optimization benefits.  Air Canada expects the agreement to result in a $50 million improvement in its operating income in 2015 alone with additional benefits in future years.  Highlights of the new agreement include: (i) the establishment of a pilot mobility agreement that provides Jazz pilots with access to pilot vacancies at Air Canada, thus allowing a significant reduction in Jazz operating costs, (ii) simplification and modernization of the Jazz fleet which will provide improved service and greater efficiency through the addition of 23 Bombardier Q400 aircraft, (iii) reduction in Air Canada and Jazz costs derived from a combination of improved fleet economics, greater network flexibility and reduced operating and labor costs, and (iv) modification of Jazz's CPA fee structure, moving from a "cost plus" mark-up to a more industry standard fixed fee compensation structure, providing more cost certainty.  Of note, this is a very recent development and its impact on Air Canada's profitability is only just starting to be priced into the stock.

·         Balance Sheet Improvement – Air Canada has been significantly improved the strength of its balance sheet through the following actions:

o    Elimination of Pension Liability - Through a restructuring completed in December 2013 the details of which can be found in the Company's 2013 Annual Report, Air Canada effectively eliminated its $3.7 billion Canadian pension plan solvency deficit.  The pension plan is now actually in a surplus position.  This was a major accomplishment for the Company as the pension liability was always a headache for management and a major concern for equity investors.  In fact, Air Canada's CEO describes the elimination of the liability as the Company's "foremost achievement" in 2013 and that "it's difficult to overstate the significance of this development."  The CEO also commented that the removal of the liability "provides encouragement to the investment community, which tended to regard the solvency deficit as some form of overhanging corporate debt which diminished Air Canada's market value.  They can now revisit their valuations of Air Canada and hopefully value us based on a higher multiple, closer to that applied to US carriers." (see 2013 Air Canada Annual Report, pg. 4).

o    Refinancing of 2010 Notes - On September 23, 2013 Air Canada announced that it had completed the refinancing of its "2010 Notes", comprised of US$600mm of 9.25% Sr. Sec. Notes due 2015, C$300mm of 10.125% Sr. Sec. Notes due 2015, and US$200mm of 12.00% Second Lien notes due 2016.  The notes were refinanced through the issuance of US$400mm of 6.75% Sr. Sec. Notes due 2019, C$300mm of 7.625% Sr. Sec. Notes due 2019, US$300mm of 8.75% Second Lien notes due 2020, as well through borrowings under a new credit facility.  According to the Company, the effective weighted interest rate on the debt decreased by ~300bps, the maturity was extended by 4 years, and the total availability under the new credit facility increased by C$300mm on substantially the same collateral pool.

Other

·         Taxes – Air Canada will likely not pay cash taxes well into the next decade.  As of the end of 2013, the Company had C$1.4 billion in tax loss carryforwards as well as C$5.3 billion in tax credits, the majority of which stem from capital cost allowances associated with the purchase of new airplanes as well as the restructuring of the Company’s pension liability, discussed above.  Updated tax carryforwards and credit numbers should be available when the Company reports 4Q14 earnings.

·         Capital Expenditures – Air Canada outlines the latest estimates for their capital expenditure commitments through 2018 in their 3Q14 M,D&A, pg. 43.

Financial Projections

Valuation Analysis

Over the next 12 months, I believe Air Canada’s stock could reach C$20/share, up >50% from current levels.  This is based on the methodologies included below.

Trading Comps

EV/EBITDA – As shown above, North American airlines are trading at 5.1x EV/2015E EBITDA and 5.0x EV/2016E EBITDA.  Based on my financial projections, Air Canada can generate C$1.75 billion in EBITDA in 2016.  Applying a conservative, discounted 4.5x valuation multiple on that equates to C$7.9 billion in EV. Adjusting for the Company’s latest available balance sheet figures (C$2.6 billion in cash, C$5.1 billion in debt) equates to C$5.4 billion in equity value, or C$18.40/share (based on a fully diluted share count of 294mm).  Adding on the FCF generated in 2015 of ~$450mm, or $1.50/share, equates to a 2015 year-end target price of ~C$20.00.

PE Multiple – As shown above, North American airlines are trading at 8.6x 2015E EPS and 8.3x 2016E EPS.  Based on my financial projections, Air Canada can generate C$2.70 in 2016E EPS.  Applying a conservative, discounted 7.5x valuation multiple on that equates to ~C$20.00/share.

Key Risks

The three main risks to the Air Canada investment thesis are the following:

·         Fuel Cost Volatility - Similar to other airlines, fuel costs represent ~30% of Air Canada's operating expenses and are one of the largest variables in the carrier's profitability.  The sharp drop in crude oil prices (Brent has fallen from ~$115/bbl in June 2014 to ~$58/bbl currently, a 50% decrease) has caused a similar decrease in jet fuel prices (New York Harbor 54-Grade (Bloomberg: JETINYPR) has fallen from ~$3.00/gal in June 2014 to ~$1.80/gal currently, a 40% decrease) which is serving as an extremely substantial tailwind for the Company.  The future direction of crude prices, and hence jet fuel prices, remains the subject of significant debate, and is not opined on here.  Rather than take a view on oil prices, the fuel cost projections presented for Air Canada are based on the forward oil curve.  Of note, Air Canada does not really hedge its fuel cost exposure.  As noted in its for 3Q14 M,D&A (pg. 48), Air Canada has hedged only 10% of its anticipated jet fuel purchases for 2015 and this is through call options at an average WTI equivalent capped price of US$101/bbl.  Accordingly, Air Canada's total jet fuel costs in 2015 will be subject to the same volatility as oil prices.

·         Potential PRASM Declines – While there are several reasons for which Air Canada could experience PRASM declines, three of them appear to be focused on more than others by investors:

o    Supply Dynamics – On the supply side, investors are concerned that Air Canada is rapidly increasing supply through rollout of rouge and will have to decrease pricing to maintain loads.  Looking at this, thus far Air Canada’s increased capacity has not placed significant downward pressure on pricing.  As shown in Air Canada’s 3Q14 results, the airline increased its Available Seat Miles from 52,540mm in the first 9 months of 2013 to 56,486mm in the first 9 months of 2014, a sizeable 7.5%.  During this time, however, PRASM’s only declined from C$0.159 to C$0.158, respectively, a 0.4% decrease.  Management attributes the lack of PRASM declines and associated capacity absorption to their view that they have been “underserving” the Canadian market for many years.  On the 3Q14 earnings call, management commented “over the previous decade, we have not grown the way we could have grown in terms of the available opportunities that exist from Canada” (pg. 8 of the transcript).  They feel that Air Canada is now playing “catch up” with the market and is only now able to achieve its real growth potential with the operating flexibility from the new pilot contract.  To this end, Air Canada is guiding to another system capacity increase of 9-10% in 2015 vs. 2014.  While investors are nervous about the magnitude of this increase, it’s important to note that a large portion of it is due to temporary “swing capacity” Air Canada is bringing into its system related to its Embraer 190 replacement.  As commented on during the 3Q14 earnings call (pg. 4 of the transcript), Air Canada is replacing 8 of its Embraer 190 aircraft with 3 Airbus 321s and 2 Airbus 320s.  Air Canada is taking delivery of the 5 Airbus replacement aircraft prior to the start of the seasonally busy summer, while the 8 Embraer aircraft are scheduled to leave the fleet at the end of the season.  So, the elevated capacity of 2015 is only temporary.  Further, management emphasized that they have the flexibility to reduce their capacity very rapidly.  On the 3Q14 earnings call, management commented that they could shrink their capacity growth in 2015 from 10% to 2-3% “pretty instantaneously” if need be (pg. 8 of the transcript).

o    Demand Dynamics – On the demand side, investors are concerned that a slowdown in Canada’s GDP, associated with a falloff in the commodity markets, will also place downward pressure on pricing.  There is truth to this argument.  The financials shown above project a 6% PRASM reduction in 2015 which is reasonably conservative.  There is potential downside (and upside) to this number, but it should serve as a reasonably baseline.

o    Lower Fuel Costs – While there is a significant concern that airlines could start to discount their fares in response to the lower fuel price environment, there are two main mitigants to this risk.  First, the airline industry as a whole has become much more consolidated over the past several years, decreasing the number of competitors and increasing the pricing power of the remaining participants.  Second, historical analysis suggests that the level of travel demand, and not fuel costs, ultimately drives pricing.  Rather than recreate the wheel here, I would suggest that readers take a look at pg. 4 of the January 28, 2015 Goldman Sachs research piece titled “Americas: Transportation: Airlines. – Airlines in Pictures: Fundamentals to Focus on – January 2015”.

The next data point on PRASM will be Air Canada’s 4Q14 results which are scheduled to be announced on February 11, 2015.

·         Canadian Dollar Exchange Rate – Air Canada has exposure to fluctuations in the CAD/USD exchange rate.  Air Canada’s cash inflows are primarily in Canadian dollars (ticket purchases) while a large portion of its outflows are in US dollars (fuel, aircraft purchases and leases, US-denominated debt, and certain maintenance costs).  To hedge its exchange rate risk, Air Canada: (i) actively converts its excess revenue in offshore currencies into US dollars, (ii) holds a significant amount of US cash reserves, and (iii) locks in foreign exchange rates through the use of derivatives.  As described on pg. 49 of the Company’s 3Q14 M,D&A, Air Canada has increased its target exchange rate coverage from 50% to 60% of its net US dollar exposure on a rolling 18-month basis.  As of September 30, 2014, ~47% of the Company’s US dollar cash outflows were covered for 2015 and ~10% for 2016.  To provide a sense of the sensitivity, in the 2013 Annual Report (pg. 66), the Company indicates that for every $0.01 shift in the CAD/USD exchange rate results in a C$48mm pre-tax income impact.  For modelling purposes, the majority of Air Canada’s exchange rate exposure is through fuel purchases, so sensitizing this to fluctuations in CAD/USD rate should capture the majority of the exchange rate risk.  This is shown in the included financial projections.

Catalyst

4Q14 and full year 2014 earnings results, scheduled to be released on 2/11/15.

Continued updates by management on the Company's cost cutting initiatives.