Description

This is an investment grade North American bond pitch.  The absolute expected return is low and the attractiveness of the return is on a relative basis to IG bond benchmarks.  A secondary purpose for this pitch is to do a write-up on one of the most interesting credits in North America, a credit that is among the highest quality non-sovereign credits in North America.  Can a company levered at 16x normalized EBITDA really have its debt be a bargain at 1.5%?  In this case, given the asset quality, yes.

Asset Overview

Nav Canada (Aa2 / AA / AA (DBRS)) is a non-profit Canadian corporation that owns and operates the civil air navigation system in Canada.  This emerged out of the Civil Air Navigation Services Commercialization Act of 1996.  Nav Canada has a legal monopoly on Canadian civil air space.  They own 7 control centers, 40 control towers, and 55 service stations.  They have ~5,000 employees, ~2,000 of which are air traffic controllers.

Nav Canada makes money by charging all flights in Canadian airspace a fee.  This includes flights that just pass through the airspace but don’t land, which includes a number of flights between Asia and the U.S.

Nav Canada has been granted broad power to enforce their fee.  For example, Nav Canada is allowed to seize the aircrafts of any airline that is behind on payments.  In June 2006, this right was strengthened by the Canadian Supreme Court, which clarified that the right extended to leased aircraft as well.

Nav Canada is allowed to charge whatever price it needs to in order to meet all its obligations.  Excess collections are recorded in a rate stabilization account, which can be drawn down in weaker periods.  This is an accrual-based non-cash account, as they are legally not allowed to maintain a cash balance. 

Nav Canada is governed by a board of fifteen.  Five represent the airlines, three the government, two the employee unions, four are independent, and the final is the CEO.

Aireon

 Nav Canada has invested US$150MM into Aireon, a space-based provider of satellite data. As of August 2020, they own 37% of the company and represent five of the eleven directors.  In 2018, NATS invested a 10% stake in Aireon at a valuation of $690mm.  Additionally, before 2022, Iridium will be selling back a portion of its stake at a valuation of $925mm.  Based on this valuation, Nav Canada’s stake is worth ~$340mm.  It’s held on the Nav Canada balance sheet at $258mm. 

On a relative basis, I think this asset is an underappreciated part of Nav Canada.  Nav Canada is ultimately a story about cash flow and market power – using their monopoly power to set prices high enough to balance debt obligations.  Thus far, Aireon hasn’t produced positive cash flow and has just been a high-growth equity story trapped inside Nav Canada. Given that Nav Canada has no equity in the capital structure, there are no equity stakeholders (or sell-side analysts) to call attention to Aireon.

However, I think there are two aspects to this that can benefit the debt.  First, two weeks ago, the U.S. Federal Aviation Administration (“FAA”) announced that they were buying access to Aireon’s data (at terms that have not been disclosed).  I think this demonstrates that there is a material likelihood that Aireon will soon start to produce meaningful cash flow, which will, on the margin, benefit the debtholders.  Secondarily, I think it is a potential spin-out or acquisition target, and those proceeds would ultimately benefit the debtholders as well.

Discussion

Because of Nav Canada’s unusual structure, financial metrics are an unimportant part of the story.  Nav Canada has monopoly power to set any price it needs to in order to recoup its costs, with the ability to seize aircrafts of delinquent payers as needed.  Thus, from a practical financial perspective, it’s impossible for Nav Canada to default on its debt as long as there is some de minimis volume of Canadian air travel upon which to charge fees.

The only theoretical ways for Nav Canada to default would be (a) if it chose to do so purposefully or (b) if there were a management snafu and it occurred accidentally.  The bondholders should theoretically be protected by and aligned with all of the board members, but particularly the four independent directors, and a chain of events that could led to a default, in either case, seems difficult to conceptualize.

Mitigating both of these risks, Nav Canada is generally considered to be well-run.  It has fewer employees now (~5k) than it did in 1996 (~6k) despite air traffic approximately doubling.  Furthermore, 2014 data suggests that Nav Canada is cheaper than the FAA per aircraft hour ($340 vs. $440) and has greater efficiency per controller (1,760 flight hours per controller a year versus 1,725 for the FAA).

Furthermore, the leadership team is well-credentialed and well-pedigreed.  The CEO is a former partner at well-respected Canadian law firm and has worked at Nav Canada for 18 years; the CFO is a former partner at a leading Canadian accounting firm and COO of Hydro One (the Ontario electricity utility).

Finally, in a default event, the secured debt is protected by a $73mm debt service reserve account.  As of August 2020, there was $834mm in cash or short-term investments, although presumably in a true default scenario that would have been spent.  Additionally, there is extensive PPE ($750MM), but the secured debt only has security over the Revenue Account (to provide security over the assets themselves could be a national security threat).

As a last resort, although technically the company operates independently of the Canadian government, it wouldn’t be hard to imagine the government providing financial restitution to the bondholders in an extreme downside scenario.

COVID Impact

Needless to say, COVID has impacted Canadian air travel.  Nav Canada hiked fees by 29.5% starting in September 2020.  The rate varies by distance and the type of aircraft but, as an example, the current fee for a ~300-person passenger flight from Vancouver to Toronto ~$5,700. 

Nav Canada is supposed to balance all of its stakeholders’ demand and is not supposed to completely jam airlines.  So, they are also engaged in further cost cutting, and have laid off ~14% of the workforce. 

On December 23^rd, they will be asking bondholders to relax certain covenants, which will need a two-thirds votes to pass.  The information agent is D.F. King Canada and I’ve reviewed the memorandum.  There are two main covenants they are seeking to relax.  The first is around incremental indebtedness, the second is effectively a mandate that the rate needs to be set to achieve a DSCR test of 1.25x. 

I think the vote is unlikely to achieve the two-thirds vote to pass, in part simply because the bondholders do not have a particular incentive to pass it.  The current rate has been set, as per management, to be able to meet all obligations over the next year, even in a year of reduced airline traffic.  However, if things were to deteriorate, especially with tighter covenants, it would just force the airlines to get jammed again with higher fees (or possibly further employee layoffs and furloughs).  While that’s an unfavorable outcome for the board of Nav Canada, and particularly the five representatives from the airlines (which is why they were incentivized to bring the issue to a vote in the first place), there’s no clear reason that the bondholders themselves should really care.

However, even if the changes were to be passed and implemented, the credit position of bonds wouldn't materially deteriorate, if at all, as would be the case with a traditional company.  Given the absolute monopoly pricing power of Nav Canada, covenants and debt loads do not drive the debt servicing capacity, with the potential exclusion of extreme boundary cases that could generate second order effects. 

Returns

Nav Canada is a AA-rated credit by Moody’s, S&P, and DBRS, and I believe that ratings band accurately represents the intrinsic credit quality.  However, on a spread basis, it historically has traded like a single-A credit.  Generally, it trades like an A1/A2 credit; however, it’s now trading like an A3 credit (see graph below).

The debt is reasonably liquid (Bloomberg BVAL score of 8 / 10) but the peculiarity of the business model, lack of comparables, lack of equity shares, and Canadian dollar exposure all serve to reduce awareness and bidding activity.  I believe the CAD exposure, in particular, is a driver of its historical spread premium relative to its ratings bands.

My preferred instrument is the 7.4% notes due 06/01/27.  First, they’re senior secured, and Nav Canada will be issuing no more secured debt (only unsecured).  The only other secured note is an amortizer, so I think there could be a scarcity bid to the 7.4% bullets, especially over time.  Secondly, the secured notes benefit from a number of credit enhancements, including a DSRA and additional covenants, including that fees must be set to establish a 1.25x DSCR (unless changed in the upcoming vote).  

I think the base case is a one-year return to a A2 credit spread, with a return to an A1 credit spread (similar to mid-2018) as an upside case.  The base case return is 2.0%, +120 bps over the benchmark, and the upside case return is 3.2%.

All of the debt is in CAD and thus introduces currency risk to investors.  I’m agnostic on CAD/USD and would leave hedging to investors’ individual discretions.

 

 

Catalyst

Rebound from COVID impact on airline travel