WestJet (TSX: WJA) is an attractive long with over 50% - 75% upside and limited downside due to its valuation (11x trailing earnings excluding net cash), growth potential, balance sheet and business quality.  Despite its many attractive characteristics, WestJet has lagged its peers by over 40% year to date and we think that has created a very good entry point for long term investors.

Brief History:  WestJet was founded in 1996 by three entrepreneurs, came public in 1999 and has grown into the 2nd largest airline in Canada after Air Canada.  WestJet flies in the domestic Canadian market, between the US and Canada in what is known as the “transborder” market and to international destinations in the Caribbean and Central/South America.  WestJet has recently made its first trans-Atlantic flight to Dublin with further international markets planned for the future.  For additional background, see the company’s annual information filings (http://www.westjet.com/guest/en/media-investors/annual-information-forms.shtml).

Summary Thesis:

1. Sustainable and Significant Cost Advantage in a Commodity Industry

- WestJet has a roughly 25% cost advantage over its closest competitor Air Canada

- WestJet’s cost advantage is sustainable due to a lack of legacy liabilities, the age of the fleet, a non-unionized labor structure and a culture of employee ownership

2. Significant Growth Potential From International Markets, Ancillary Revenues and Encore

- WestJet’s cost advantage can lead to further market share gains in the transborder (US-Canada) and international markets

- Introduction of ancillary revenue streams such as checked-bag fees could yield substantial earnings growth

- Encore (WestJet’s regional airline) has additional growth potential through 2018

3. Valuation Is Attractive

- Despite a history of superior business and financial performance, WestJet trades at a significant discount to its intrinsic value and its peers

4. Why this Opportunity Exists

- WestJet’s mispricing can be attributed to near-term fears over Canadian dollar depreciation, along with the company’s lower profile

1. Sustainable and Significant Cost Advantage in Commodity Industry

Since its IPO, WestJet has maintained a substantial cost advantage against Air Canada, allowing it to both “take” and “create” market share by expanding into new markets that were previously uneconomic for higher cost competitors.

WestJet’s sustainable cost advantage stems from several factors.   First, the company’s labor force is entirely non-union.  This is an enormous cost advantage compared to the heavily unionized employees at Air Canada and nearly every other competitor.  Even low-cost pioneer Southwest Airlines has 83% of its employees represented by a union.  The only other major airline that was entirely non-union was JetBlue until recently, and WestJet maintains significant competitive advantages over them as well.  National regulations only permit domestic carriers to fly point-to-point within a country, so JetBlue and WestJet do not compete on domestic routes.  Therefore, while JetBlue must compete with other low-cost carriers such as Southwest and ultra-low-cost carriers such as Allegiant and Spirit, WestJet’s domestic markets are protected and have no other significant competitor except for higher-cost Air Canada.

Second, WestJet’s average fleet age is substantially lower than its peers, resulting in lower maintenance costs and higher fuel efficiency than peers.  Fuel is the single largest expense for airlines, so WestJet’s nearly 20% lower fuel usage per available seat mile is a significant competitive advantage over Air Canada.  Likewise, WestJet’s maintenance cost per available seat mile is roughly half of Air Canada’s.

Third, WestJet maintains one of the strongest balance sheets in the industry, with a substantial net cash balance and much lower leverage than peers on lease-adjusted and pension-adjusted metrics.

Lastly, WestJet’s significant employee ownership fosters a culture that differs from many of its competitors. As depicted below, these competitive cost advantages have allowed WestJet to increase its domestic market share to over one-third, creating a duopoly with Air Canada.  

2. Significant, Early-Inning Growth Potential From International Markets & Ancillary Revenues

WestJet’s domestic success is being replicated in the US-Canada “transborder” and international markets.  As shown below, WestJet is also taking market share in the trans-border market where it has reached a 20% share from less than 5% a few years ago and in the international market, where it is just starting to emerge as a significant competitor.  Given the common competitive advantage it has against its peers in these markets, we think WestJet has significant room for growth, just as it did in the Canadian domestic market.  

Additionally, we think WestJet has other levers for earnings growth beyond just market share gains, namely ancillary revenues and its regional short-haul service called Encore.

Ancillary Revenues:  WestJet is one of the only remaining airlines to not charge for checked-bag fees, along with Southwest and JetBlue.  Industry checks and management commentary suggests that checked-bag fees are a matter of “when” and not “if.”  Checked-bag fees flow directly to profits, as WestJet is already carrying the bags but not receiving the revenues.   We think part of the premium multiple that is given to Southwest is because of this pent-up earnings power, yet WestJet is given no such benefit.

WestJet’s Encore regional service can also add significantly to earnings at maturity.  Encore focuses on smaller markets and WestJet looks to both “take” market share and “create” market share by stimulating traffic in previously underserved markets.  WestJet plans to grow Encore to a fleet of 40 Bombardier Q400 aircraft, up from 8 at 2013 year-end.

We think that the implementation of checked-bag fees and the roll-out of Encore could very conservatively increase earnings by over 50%, on a stock that trades at 11x earnings.

3. Valuation

One of the interesting aspects of WestJet is that despite its poor stock performance YTD and its valuation, it is certainly not a “broken” company.  Quite to the contrary, the company has generated exceptional business and financial results since its IPO in 1999, yet still trades at a discount to its peers and its intrinsic value.   Since WestJet came public, it has outperformed all of the airline peers that were public at the time, along with the S&P 500.  (Note:  several current public airlines have gone bankrupt, some more than once, and WestJet has still managed to outperform their re-org’d equities, such as UAL and Air Canada).

WestJet has also managed to grow revenues and earnings at over 20% annually, while being very profitable through the cycle.

Given this exceptional track record, we find it surprising that WestJet trades at significant discounts to all of the peers.  We think WestJet deserves a multiple in line with other low-cost carriers and that the stock has 50% upside.

4. Why This Opportunity Exists?

We believe the current valuation discount for WestJet has to do with near-term fears about the impact of the decline in the Canadian dollar.  Since WestJet has a substantial portion of its revenues in the Canadian dollar, while many of its costs such as fuel are priced in US dollars, a weak Canadian dollar hurts the company’s profitability.  Early in 2014, the Canadian dollar declined substantially against the US dollar, dropping from near parity for most of 2013 to as low as $0.90.  The weakness caused sell-side analysts to downgrade earnings estimates and price targets for Air Canada and WestJet.   While Air Canada’s stock has rebounded, WestJet’s has still lagged the overall industry by over 40% year to date.

For a variety of reasons, we believe that the Canadian dollar weakness will only have a brief, temporary impact on WestJet’s business.

First, well-run businesses are dynamic entities that can adapt to different operating environments.   WestJet’s management team has several options available to them to offset the pressures from the Canadian dollar, such as raising fares or adding surcharges for ancillary items.  The most obvious surcharges would be for checked-bag fees.  The revenues generated by checked bag fees would dwarf the negative impact of the Canadian dollar.

Second, the Canadian dollar also impacts WestJet’s main competitor, Air Canada, which, in addition to fuel costs, has significant US dollar denominated liabilities.  So long as these effects are felt by Air Canada as well, WestJet’s competitive cost advantage should remain intact.

Third, and most importantly, WestJet’s own history illustrates the business’ ability to thrive under almost any market environment.  As illustrated below, WestJet has managed to be solidly profitable and earn a healthy return in vastly different currency, commodity and economic environments.

As shown above, WestJet has been able to operate well in periods where the Canadian dollar or crude oil prices were either low or high and either increasing or decreasing.  In fact, the only period in which the company’s returns suffered significantly was the introduction of an irrational competitor called JetsGo.  JetsGo was launched as a low-cost airline in Canada in 2001 and quickly grew to capture a 10% share of domestic capacity.  However, JetsGo gained their market share by irrational pricing and by 2004 was in financial distress.  The airline filed for bankruptcy in 2005.  

Therefore, we believe that the most significant operational risk to WestJet is not oil prices or currency fluctuations, but irrational competitive behavior.  After the failure of JetsGo and given the concentrated market share positions of Air Canada and WestJet, we believe there is little room for new entrants (such as Porter Airlines) to grow substantially.  Due to WestJet’s sustainable cost advantage against its larger domestic competitor and its international peers, we think WestJet has significant room for growth with an attractive valuation.[1]

In summary, we think that WestJet is attractively priced, with some important catalysts such as the implementation of checked bag fees, which along with additional market share gains and the growth of Encore, leads to significant earnings growth and modest multiple expansion to get a 50 – 75% return on the investment: