RE:Scotia Bank update 20 SEP 15Scotia's view in-depth:
Strategy on Track to Meet Targets
Atlantic and U.S. Transborder strength offsetting Western Canada oil market pressures. Europe continues to be very strong for AC, driven by more Rouge flying, densified 777 aircraft, and new market penetration (eg. Amsterdam), all of which are contributing to healthy margin expansion in the Atlantic segment. The U.S. Transborder segment also remains strong despite some investor concerns on Canadian travel demand to the U.S. due to the weak CAD. This growth is buoyed by expanding sixth freedom traffic, relatively healthy demand out of Central Canada and a rising number of Canadians who own vacation homes in the US. The Asian market is mixed, with yield pressures in markets such as Japan but – somewhat surprisingly – stability in China despite industry capacity pressures and a weakening Chinese economy. In our view, government approval of the proposed JV with Air China would provide a further boost for AC in the Chinese market. The domestic segment is facing a bout of weakness on the back of both macroeconomic uncertainty in Alberta and capacity growth from WJA as Encore expands and WJA introduces 767 domestically (for ETOPS certification) in 2H/15. AC’s 3%-4% domestic capacity growth in 2015 is, however, relatively limited compared to international market expansion (11.5%- 12.5%), which we believe is prudent considering domestic yield pressures and AC’s more limited domestic toolkit (essentially no Rouge and high-density widebody operations within Canada).
Sixth freedom traffic continues to be robust. Management remained bullish on progress in scooping up a greater share of sixth freedom traffic transiting from the U.S. and southern markets through Canada and onwards to Europe and Asia. AC reiterated the target of 1.5% market share (from current 0.8% levels) for U.S.-Europe/Asia bound non-U.S. carrier traffic, with particularly strong performance coming through at the Toronto Pearson hub. Management noted that there are, on average, several sixth freedom passengers transiting per widebody aircraft with flow helping both mainline and Rouge load factors.
AC is well positioned to meet 21% CASM reduction goal but macro environment brings uncertainty, in our view. Management acknowledged that the new EBITDAR margin, ROIC, and leverage targets disclosed at the recent investor day (Exhibit 1) are aggressive but achievable. The targets are driven by AC’s focus on unit cost reductions with Rouge expansion as one of the key pillars. Rouge is expected to be fully built out by summer 2017 with a fleet of 50 aircraft (22% of total fleet vs. 16% today). The MAX, new Jazz CPA and additional fleet reconfigurations, among other items, are all elements supporting AC’s 21% CASM reduction goal by end of 2018 compared to 2012 levels. We believe that the macro environment is uncertain, which is a risk for AC’s strategy as this is contingent on continued ASM growth driving CASM reductions. As such, in a weaker economy there is risk that the additional capacity may not be absorbed by the market. While AC has flexibility to reduce its growth, it would come at the expense of unit costs. Management, however, remains confident in the resiliency of the new AC business model, which is focused on international diversification.
How will WJA’s London expansion affect AC and the market? WJA announced new 767 (and one 737) routes from six Canadian cities to London Gatwick beginning in May 2016, competing vs. AC and TRZ operations to London Heathrow and Gatwick. While AC rightly is confident in Rouge’s unit cost structure vs. WJA (on average 4% more seats per 767 at AC Rouge), the specific WJA London route will also compete against mainline AC operations into the city. This may result in some fare compression for both AC and TRZ, as WJA has launched the routes with aggressive pricing to stimulate the market. We believe that this pricing is introductory and should start to move up over time. Nonetheless, the risk of yield compression on certain routes is there. From a product perspective, however, AC mainline is much more attractive 18 with appeal to both business travelers and aeroplan members. While London is not as large of a connecting traffic market relative to some other European cities, Gatwick airport is (in terms of passenger traffic) as large as Toronto’s Pearson airport and will offer WJA passengers a selection of LCC carriers (eg. easyJet, Vueling) for onward journeys within Europe at low fares.
Balanced plan for capital return to shareholders. Debt repayments will retain precedence with ~$9B in future capex. While shareholders were excited with the news in May 2015 of a new 3.5% buyback program post the pension opt-out, management has been clear that the priority going forward will remain de-leveraging of the balance sheet. Despite the massive fleet capex for new 787s and 737 MAX aircraft, AC is targeting a leverage ratio of 2.2x, which is essentially flattish to slightly down from current 2.3x levels. Management also continues to work on unencumbering aircraft and related assets, improving from less than $100M three years ago to $1B currently. This provides more flexibility in managing the cost structure during recessionary times.