Description

I recommend buying Air Canada's 4% convertible bonds due July 2025 at 117 (current offer side) and believe they can trade to 154 over the next 12 months, generating a 35% total return. I think Air Canada's converts offer the best risk/reward in the airline space for the following reasons:

• Canada will lift onerous restrictions/quarantines on international travel as the country progresses further with its as yet strong response to Covid-19
• Strong cost management and balance sheet stewardship pre-crisis leave Air Canada better positioned than most large North American peers to withstand a prolonged passenger traffic recovery
• Left-tail outcomes are mostly off the table with C$10 billion of cash and up to C$6bn of unencumbered asset value as of June 2020, against expected 2H'20 and 2021 cumulative FCF burn of ~C$3bn
• By late next year, investors will turn to 2022 EBITDAR of ~C$2.5bn, which while well below 2019 EBITDAR of ~C$3.75bn, could get the stock to C$26 per share, up 60+% from current levels

My base case valuation of C$26 on Air Canada's stock one year from today is based on C$2.5bn of 2022E EBITDAR, 6x EV/EBITDAR, C$3.4bn of net debt and leases, C$3.1bn of cumulative remaining cash burn. The convert is denominated in USD, and 40% vol and 750 bps credit spread get you to 154 on the convert (in USD) one year forward for a 35% total return. 

Below is a brief company overview as well as further detail on the summary thesis above.

Brief company overview

Air Canada is Canada's largest airline with ~55% market share in Canada. WestJet, which was acquired by Onex in 2019, is Canada's second airline with ~35% estimated market share. Air Canada carried 51 million passengers in 2019 and generated C$19bn in revenue and C$3.75bn in EBITDAR. Air Canada is a sixth freedom airline, meaning it flies many U.S. nationals on long-haul trips with a layover in Canada. The company's international and long-haul heavy traffic composition leaves it relatively weaker positioned vs. U.S. low-cost carriers to emerge from Covid-19, where early recovery is primarily taking place in short-haul leisure-focused traffic. Air Canada's 2019 traffic breakdown by revenue passenger miles was 22% domestic, 17% U.S. Transborder, 31% Atlantic, 21% Pacific, and 9% other.

Under CEO Calvin Rovinescu, Air Canada improved ROICs from single digits well into the mid-teens, brought its pension from more than C$4bn underfunded to a C$2.5bn surplus, and reduced leverage to 0.8x by year-end 2019 from 5x in the early 2010s. The company also bought back its loyalty program, Aeroplan, in a move that now seems prescient following United's and Delta's successful mileage program-backed financings this summer. 

Gradual lifting of travel restrictions/quarantines will release pent-up international traffic demand

Given Air Canada's focus on sixth freedom traffic, it is more reliant on governments lifting international travel restrictions and relaxing quarantine requirements than on a recovery in latent passenger travel demand. Canada, like most other first world countries, has handled Covid-19 much better than the United States to date (Canada reported an average of 6-7 Covid-19 deaths per day in September) and should be well-poised to safely resume international travel with similarly-positioned countries. Management spoke convincingly on the Q2 earnings call about scientific research to date that suggests very little risk of transmission on a plane, and urged the Candian government to follow other G20 countries that at the time had infection rates under control in embracing a science-based approach to reopening international travel. Currently, travelers entering Canada must have a plan to quarantine for 14 days (including documenting access to a place to stay, and how one will access groceries and medical care) even if they are able to pass a health assessment at the point of entry and if they are not displaying any symptoms. Management said there is "no question" there is pent-up demand for personal and corporate travel, and that a customer survey highlighted the mandatory quarantines as the primary inhibitor (nobody wants to take a two-week vacation only to have to take another two weeks away from work to quarantine).

Air Canada's pre-crisis turnaround and strong balance sheet leaves it well-positioned to navigate a longer-term recovery in passenger traffic

Prior to Covid-19, Air Canada was coming to the end of a 5+ year turnaround plan that saw the company grow revenue by more than 50%, generate a signficant cost advantage over its Canadian competition, and significantly strengthen its balance sheet. From 2012 to 2018, Air Canada cut adjusted costs per average seat mile (CASM) by 14%; over the same period, WestJet's CASMs increased by 9% and U.S. network carriers' CASMs increased by nearly 17%. In 2012, Air Canada's pension plan was C$4.2bn underfunded; by year-end 2019 the plan had a surplus of C$2.5bn. Finally, Air Canada was on the cusp of investment grade credit ratings after having reduced net leverage from >5x to 0.8x at year-end 2019. Management has responded aggressively to Covid-19 by quickly cutting costs and by raising >C$5bn of liquidity YTD, and had >C$10bn of cash and investments on the balance sheet as of June 30. In addition, Air Canada has C$2.5bn of unencumbered hard asset value (primarily planes and spare engines) and could likely raise debt on attractive terms against the company's loyalty program, Aeroplan. The company has provided limited financial detail on Aeroplan after buying in the program in 2019 (Air Canada had previously spun out the program into publicly-traded Aimia), but recent financing activity by United and Delta against their loyalty programs (Mileage Plus and SkyMiles, respectively) implies Air Canada could raise C$3.5 to C$5.5bn of incremental liquidity based on the company's revenue passenger miles and Aeroplan's deferred revenue. Finally, Air Canada has access to the Canadian government's Large Employer Emergency Financing Facility (LEEFF, similar to CARES in the U.S.) program, under which the company could obtain additional financing. I estimate Air Canda will burn just C$3.1bn over the next 12 months, and ~C$4bn cumulatively as passenger traffic recovers on a path slower than consensus expectations (see exhibits). 

With most left-tail outcomes off the table, Air Canada's stock is too cheap as investors start to focus on 2022, but the converts offer superior risk/reward

I believe 2021 will be another challenging year for North American airlines and for Air Canada specifically, due to a slow recovery in corporate travel and continued reluctance to lift quarantines (and I acknowledge this is a fully-consensus view). Yet I expect travel sentiment to gradually improve along with progress toward a Covid-19 vaccine and toward improved rapid-testing, along with consumer education around the safety of air travel. Thus I think Air Canada can generate EBITDAR of C$2.5bn and FCF of C$1.4bn in 2022 with RPMs still 18% below 2019 levels, and think investors will have a line of sight toward this trajectory by next summer. Assuming 6x TEV/EBITDAR and C$3.1bn of cash burn over the next 12 months, Air Canada equity has 60%+ upside to C$26 (still well below sell-side targets in the mid-C$30s). The converts are USD-denominated, but have a strike price of C$15.35. Assuming CADUSD at current spot of 0.76, 40% vol, and a 750 bps credit spread, the converts have 35% total return upside to my base case target price of 154. I prefer the convert exposure to the stock given superior downside protection: at 117 on the offer side, the converts create the company at 2.1x 2021E EBITDAR of C$1.7bn and 1.4x 2022E EBITDAR of C$2.5bn (4.5x and 3.0x, respectively, incorporating C$4bn of cash burn), and have downside of just 18% to ~92 in a moderate downside scenario (C$10 share price, C$4.6bn cash burn, and 900 bps credit spread; see tables).

Risks

The personal and corporate travel recovery is inherently unforecastable. In the event of a prolonged traffic recovery, Air Canada is at a decided disadvantage compared to U.S. low-cost carriers with no international traffic exposure and a focus on faster-to-recover VFR (visiting friends/relatives) and domestic leisure traffic (FWIW, I also like Spirit Airlines 4.75% converts and might have written up those if not for a recent SAVE EETC write-up). Air Canada has also benefited from industry consolidation over the last decade and to date hasn't seen aggressive ULCC competition.

Convertible Bond Valuation 

Forecast Summary

Capital Structure/Valuation

Catalyst

* Gradual relaxation of international travel restrictions/quarantine requirements as rapid testing improves and becomes more prevalent

* Greater acceptance/consumer education around aircraft air filtration systems and air travel safety