NOTES DEAL UPSIZED - an interesting few weeks ahead Convertible notes upsized to US$650 million, perhaps not surprisingly given that it is a nice yield that can be fully hedged (the arb shorting was highlighted by AC in the prospectus as a near-term risk). The equity raise of CDN$500 million gives them pro-forma March 31 liquidity of $9.4 billion, which will increase by $211 million if the full greenshoe is exercised. That potentially increases liquidity to in excess of $9.6 billion (pro forma March 31, 2020), less the 4% banking fees on this deal (CDN$56 MILLION DOLLARS). One thing is clear – the more expensive equity piece wasn’t necessary, given the liquidity even without the equity issue. So why did they do it?
Reading the prospectus, it is clear that the equity deal was likely the add-on to satiate the debt holders and not AC’s first choice, given the dilution and unnecessary from a liquidity perspective. As stated in the prospectus, “The completion of the <equity> Offering is contingent on the completion of the Concurrent Convertible Notes Offering, so the Offering will not be completed if the Concurrent Convertible Notes Offering is not completed…”. The equity piece is not the most appealing part of this transaction, those are the Notes (hence the upsized deal due to demand). And they are cheaper capital for Air Canada.
The pain of being a common shareholder refers to where he/she stands in the capital structure. At the very bottom. All the debt instruments currently outstanding by Air Canada have to be paid back in full at some point by (a) issuing new debt, (b) generating free cash flow to pay it off, (c) issuing more equity. The equity piece is the one which takes on the volatility associated with upside and downside risk in earnings prospects. And as shown in this transaction, the debt holders and bankers can mandate that equity is raised, despite it being much more expensive than debt (the convert was only 4% yield with much higher strike on the conversion price than offering price on the equity). And it doesn’t take a rocket scientist to note that the lead bankers for this transaction were also the banks that provided the >$1 billion in debt drawn in March from the 2016 and 2018 Credit Facility (prospectus page 20). It isn’t uncommon for banks providing debt lines to also lead equity deals (as they are risk less and high fees for the banks). This sucks, but part of the game and being involved with a levered company in a black swan downturn. Equity holders enjoy the leverage in an up cycle and vice-versa during the period we are in now.
The JETS index (AC’s R-squared correlation with this over past 3 months has been over 0.8) just rolled from its most overbought level since mid February and fell over 4% yesterday. Next Friday, institutions (some new to AC and some existing holders) will receive 35.4 million shares re: the common share issue (with the 15% oversell). The buyers will likely be a combination of various styles, from fast money to long term hold and everything in between. The underwriters have 30 days to cover their short position of 4.6 million shares. An unknown number of the accounts in the buying syndicate will be speculating on continued momentum rally in the “reopen” stocks, which includes hotels, airlines, casinos, retail, etc. If that happens and share price holds above deal price consistently, the entire 15% Greenshoe will be exercised and longs will likely be pleased. If it falters, you will see buying opportunities (aka lower prices) as some of these faster money accounts bail, as the Banking Syndicate only has so much dry powder. If one can see that the share price can’t hold anywhere near deal price, this will provide ammo for bears and shorts, knowing that once the Banking syndicate stops supporting it, gravity pushes it lower, and nervous hedge funds and long only’s who might have played on the deal reduce exposure or short to fix downside exposure, exacerbating the pressure. This is where trading opportunities exist, when one recognizes what is going on.
Price and volume should be watched closely. The next few weeks will be interesting.
And my view for the equity direction – because of the cash burn and time it will take for AC to regain its margin structure (as a smaller airline, reduced higher margin corporate travel and with more net debt), share price of $7-11 a year from now more likely than $19-23, based on my own views of where EV/EBITDAR will shake out at that point. In other words, the net debt continues to crowd out the equity in the valuation. But that is what makes a market…everyone entitled to his/her opinions. Good luck…