Description
Out of Bankruptcy: Based on the current share price of ~$17.22 (“ACEAF” - US dollars), Ace Aviation is trading around 8x F2005 earnings, has an upside potential of 58% and downside of -12%. The massive restructuring has provided significant cost reductions. Together with the new revenue strategy, new capitalization structure and its market position in Canada (e.g., global network, Star Alliance, Aeroplan, etc.) the company appears to be well positioned going forward. Any reduction in oil prices will be an added bonus.
Ace Aviation Holdings (the holding company of the many business divisions of the old Air Canada) completed its restructuring process and exited Chapter 11 bankruptcy protection last week with reduced operating costs, a strengthened balance sheet, a reorganized corporate structure and has a fleet renewal and commercial strategy intended to achieve sustained growth and profitability. Specifically, Ace Aviation Holdings is expected to generate positive operating income and cash flow and has reduced its net debt and capitalized operating lease obligations from approximately C$12 billion to less than C$5 billion a decrease of nearly 60%. Also, Ace Aviation has raised C$1.1 billion of new equity capital and has C$1.9 billion of cash on its balance sheet. The creditors in this deal who own most of the equity are GE Capital, Deutsche Bank who invested C$850 million and distressed asset specialist Cerberus Capital who invested C$250 million.
I do not have to remind everyone at the VIC that airlines are not the best businesses. But if you must, the best time to buy these stocks is once they get out of bankruptcy and sell a year before they go back in. Coincidentally, Air Canada’s reemergence out of Chapter 11 comes about one month after US Airways, the 7th largest US Airline, sought protection from creditors for the second time in two years. Also UAL the world’s 2nd largest carrier has been operating under court protection and Delta Air Lines the no. 3 US carrier has threatened to file. With that said, proceed with caution.
About the company:
ACE Aviation Holdings is the holding company for Air Canada and all of its subsidiaries, emerged from bankruptcy protection on Thursday, September 30, 2004 and began trading on Monday, October 4, 2004 on the Toronto Stock Exchange (ACE/RV CN -- on Bloomberg). The company has just begun trading in the US. Air Canada is Canada's largest domestic and international full service airline and the largest provider of scheduled passenger services in the domestic market, the Canada-U.S. market as well as in the Canada-Europe and Canada-Pacific markets. Air Canada operates a significant domestic, trans-border and international network. Passenger transportation is the principal business of Air Canada and, in 2003, represented 82% of its total operating revenues. Air Canada operates an extended global network in conjunction with its international partners. Air Canada is a founding member of Star Alliance, the world’s largest airline alliance group. The other members of Star Alliance include United Airlines, Lufthansa, SAS, Thai Airways, VARIG, Air New Zealand, All Nippon Airways, Singapore Airlines, British Midland ("bmi"), Austrian Airlines (including Lauda Air and Tyrolean Airways), Asiana Airlines, Spanair, LOT Polish Airlines and U.S. Airways. Through its strategic and commercial partnerships with Star Alliance members and several other airlines, Air Canada offers service to over 700 destinations. In the Canadian market, the Corporation competes with several scheduled and charter airlines most of which are low-cost airlines. In 2003, WestJet, a low -cost carrier based in Western Canada, and the Corporation’s largest scheduled domestic competitor, expanded its domestic ASM capacity by approximately 48%.
What Happened and Why Air Canada Filed for Chapter 11:
To fully understand the this opportunity, we took a look at what happened. Commencing in the summer of 2000, Air Canada was faced with increasing competition from domestic low-cost airlines. Domestic low-cost airlines, together with growing consumer expectations for lower fares, have driven down yields. In addition, the bursting of the technology bubble in 2000 caused a substantial decline in the demand for premium business travel. Air Canada cut its planned 2001 capacity growth to zero, parked up to eight older wide-body aircraft and reduced employment levels by 3,500 employees, primarily through voluntary separation packages and attrition. However, Air Canada was not fully able to respond to this new environment given the undertakings provided in connection with the acquisition of an Canadian airline that they did a year earlier which notably prevented Air Canada from starting up a planned low-cost air carrier in Eastern Canada before September 2001 and also prevented Air Canada from significantly reducing labor costs. Air Canada also experienced, in the past few years, a succession of negative events, each of which has had a dramatically greater impact on Air Canada than upon its domestic competitors given Air Canada's large trans-border and international travel components. Recent years have been characterized by an overall recessionary economic environment which led to a general weakened demand for Air Canada's services and a substantial drop in demand in the premium corporate and business travel markets. The adverse consequences of a declining economy were compounded by the September 11, 2001 terrorist attacks and the 2003 SARS outbreak which led to a further reduction in consumer demand. Given its limited ability to reduce labor costs and having effectively fixed aircraft fleet costs, Air Canada was unable to bring down its cost structure to a level necessary to respond to the decline in traffic and, generally, to the new landscape of the airline industry. The September 11, 2001 terrorist attacks also triggered substantial increases in insurance and airport security costs. For 2002, Air Canada's annual aviation insurance costs increased by approximately $71 million compared to insurance costs in effect prior to September 11, 2001. Subsequently, Air Canada also grounded many of its aircraft due to excess capacity. As most airlines were generally experiencing similar overcapacity problems, Air Canada's ability to dispose of such aircraft was severely restricted. The geo-political instability that has characterized recent years, including the Iraqi crisis, brought uncertainty to the global economy and contributed to increased volatility in fuel prices. Fuel prices, an important factor for Air Canada, were at a near record level in the first quarter of 2003. In this context, Air Canada experienced a worsening financial position exemplified by a net loss of $1.315 billion for 2001 and a net loss of $828 million for 2002, as well as the downgrading of its senior debt rating by Moody’s and other rating agencies. As at December 31, 2002, Air Canada had total assets of book value of $7.412 billion and total liabilities of $9.700 billion. In early 2003, Air Canada's revenues began to be severely impacted by: (i) the advent of the Iraq war; (ii) the SARS outbreak; and (iii) the rapid expansion of WestJet and other low-cost carriers. In combination, these factors caused Air Canada's passenger revenues to decline by over $1.3 billion versus 2002. The operating losses of 2001 and 2002 had already significantly diminished the liquidity of Air Canada and alternative sources of funding were lost. Air Canada elected to restructure their operations, debt and capitalization under CCAA (Chapter 11) protection on April 1, 2003. Air Canada's senior unsecured debt rating to C and S&P to D.
What Has Changed Since the Restructuring:
COST SAVINGS: The restructuring process under bankruptcy protection has provided Air Canada with the opportunity to implement changes to its cost structure that will reduce costs by roughly $2 billion between 2003 and 2006. Air Canada has been able to negotiate a series of labor agreements that will reduce labor costs by $900 million dollars by 2005, with $400 million coming between 2004 and 2005. The decline in salary and benefits will average about 6%. With the introduction of the new B-scale, all new employees will start at a lower compensation level and will have more salary rungs; making it a longer process for them to move up the scale to higher seniority and salary levels. Work rule changes contained in the new contract will increase the productivity of employees. All employees also gave up one week of vacation time as well as two statutory holidays. In the Air Canada Technical Services division, there will now be fewer job categories and classifications and flexibility in seasonal scheduling. In addition to the labor savings, Air Canada was able to reduce their aircraft rent payments by repudiating some leases on older aircraft, renegotiating all other aircraft leases to more favorable terms and by downsizing its fleet in general. These changes have already saved Air Canada $600 million and an additional $100 million savings expected in 2006. Cost savings from all other areas will amount to $400 million and will be achieved by the end of 2004, with half of this amount already achieved to date. These reductions in cost make up the $2 billion in cost savings that Air Canada expects to achieve by 2006.
NO TAXES: Air Canada will not have to pay any cash taxes for the foreseeable future. However, management has indicated it will report earnings after applying a 33% tax rate. Despite this it should help with cash flows.
NEW STRATEGY: Given the restructuring, Air Canada issued 101 million shares on a fully diluted basis. The shares (share rights offering) have been trading actively through auctions and over-the-counter trading. Air Canada’s new revenue strategy going forward is based on four concepts: increasing frequencies, leveraging international footprint, leveraging premium class and leveraging its other businesses. Air Canada’s mainline fleet will be transformed within two years into one that includes newer, more fuel efficient jets that will maximize revenue per revenue passenger mile and revenue per available seat mile. Air Canada is a member of the Star Alliance, giving it and its passengers access to a network that stretches around the world. Leveraging premium class is something Air Canada’s domestic competitors (WestJet and Air Transat) cannot do. Air Canada now offers Tango fares on all of its flights that matches the lowest fares offered in the market. However, Air Canada does offer more flexible fares (at higher prices) and allows Aeroplan members to earn miles. These types of “perks” allow Air Canada to earn premium revenue as flyers pay-up to have the ability to make changes to their flight. Compared to 2002, Air Canada has given up about $1 billion in revenue to competitors. Of that, roughly $550 million has been lost in the domestic market while $450 million has been lost in the US trans-border market. All other international markets have been flat. Air Canada is expected to generate $8.9 billion in revenue in 2004.
Valuation:
Needles to say, Air Canada’s results are sensitive to movements in fuel prices, more so than other companies. I am not an oil futures expert, but many are forecasting a normalized fuel of $45 to 50 per barrel in both 2004 and 2005. The company has indicated that a $1.00 movement in the price of oil translates into a $0.28 movement in earnings per tax, $0.19 after-tax. These figures, however, assume an exchange rate of $1.40 while exchange rate currently is about $1.26. In addition to this “normalization” process, fuel costs will also be tempered by using newer, more fuel-efficient aircraft that will use less fuel. As Air Canada increases its footprint in international markets, lengthening its stage length, the company will undoubtedly incur lower fuel costs. Based on the outlook for the next two years fair value is around $25 to $30 per share -- based on EV/EBITDAR multiple of 5.5x F2005 estimates of $1.2 billion. The downside for the shares is $15. All in US dollars.
Catalyst
1. Margin expansion due to Air Canada's new low-cost platform
2. Market share gains due to price competitveness
3. Increased coverage on the Street
4. Fuel price reduction can be a powerful catalyst for all healthy airlines
5. Overall economic improvement