Seeking Alpha article - Nov. 20th - 3:04 pm
Summary
Air Canada helped by managements’ cost cutting efforts and restructuring plan could transform itself into a best-in-class operator.
Opting out of pension-funding agreement to help conserve/return cash to shareholders and strengthen balance sheet.
Weakening CAD, while neutral in terms of financial perspective should help gain market share in transborder flights.
Sector rerating on the cards helped by healthy traffic growth, lower fuel prices, improving profitability and disciplined industry capacity additions.
Air Canada (OTCPK:ACDVF) could easily be the best airline success story for 2015 and it is in the midst of a major turnaround with potential for multiple rerating. The company has shown a lot of operational and financial discipline with the management initiatives really paying off.
Let us start with its Q3 2015 earnings, where its performance was good before going into the investment thesis. During Q3 2015, i) EBIT margins grew 6.5ppts y/y to 20.3% on lower costs (including fuel), ii) ROIC surged to 16.2% (cf. to 11% a year ago) and iii) 9M free cash flow was positive at CAD592m (cf. -194m in prior year). We believe that the stellar performance with sequential improvement every quarter shows that Air Canada is in the early stages of its successful transformation.
# Reason 1: Cost cutting efforts to make Air Canada one of the best-in-class operators: Its CEO, Rovinescu is executing well on its target to cut operating expenses (measured by the cost to fly each seat a mile) by at least 15% through 2018 helped by i) packing more seats on long-haul aircraft, ii) expanding the low-cost Rouge leisure unit and ii) ordering new fuel-efficient jets such as Boeing Co.'s 787 Dreamliner. Now let us analyze the logic behind these actions and how Air Canada is faring.
- Fuel costs (ca. 30% of all expenses) are one of the major target for all airline CEO's to cut costs. The new Dreamliners would have ca. 29% lower fuel and maintenance expenses compared to the currently used Boeing 767s. Also, its decision to downsize its Embraer SA E190s fleet by 20 aircraft units with 5 narrow-body Airbus and 5 Boeing 767s will help slice operating costs by 10%.
- It's renegotiated deal with partner Chorus Aviation (OTC:CRHVF), the operator of several short-haul flights could lead to benefit of USD550 million between now and 2020.
- The capacity increase of ca. 10% this year will come from budget carrier Rouge, which serves leisure destinations mainly in North America, Europe and the Caribbean. Its lower cost structure will allow the carrier to operate on capacities that were previously deemed unprofitable and provide flexibility in utilization as its fleet size grows. The induction of Boeing (NYSE:BA) 767s into Air Canada Rouge to maintain its lower cost structure, along with the introduction of Boeing 787 planes into the mainline fleet would help serve new international destinations with significantly lower operating costs.
- The airline is also busy finding new avenues of revenues and in February 2015 started levying the new baggage fees that is projected to generate annual sales of ca. USD60m.
# Reason 2: Opting out of pension-funding agreement to help conserve and return cash to shareholders: Air Canada's opting out of its pension funding agreement with the federal government could provide significant upside. The deal, which was struck in 2013 when the airline's pension was staring at an USD4.2 billion deficit, included a prohibition on dividends and share buybacks, as well as a cap on executive pay. As a result of solid returns coupled with a new investment strategy, it has reversed the deficit into an estimated surplus of USD1.2 billion. This allowed Air Canada to opt out of the funding agreement that could free up USD1.1 billion of cash over the next six years will provide more flexibility to manage liquidity position and structurally transforming both its balance sheet and operational network. It has also announced a buyback of up to 3.5% of its outstanding stock that would be accretive to EPS and equity value in the near term.
# Reason 3: Strengthening balance sheet helped by rising FCF deployed in deleveraging: The airline continues to generate significant amount of free cash flow which the management is deploying to deleverage its balance sheet and structurally transform its fleet for the long term. It is almost close to reaching its 2.2x debt to EBITDAR target that it had set for 2018 (currently at 2.2x), while its unrestricted stood at USD3.3bn at the end of Q2 2015 (cf. USD2.9bn in 2014).
# Reason 4: Weakening CAD… more benefits than drawbacks: Air Canada's business has a "natural hedge" between the revenues denominated in CAD and fuel cost priced in USD, that the benefit and negatives evenly nets out from a financial standpoint. Under the current scenario, the weakening of CAD evens out the corresponding drop in USD crude prices. We believe that Air Canada could benefit from its US peers scaling down their transborder flights as a result of weaker Canadian dollar and gain market share.
# Reason 5: Attractively valued and secular re-rating of the industry to drive stock price upside: The stock currently is currently trading at ca. 3.5x EV/EBITDAR. This is a steep discount of 25% compared to peers, despite being in the middle of a transformational turnaround that would be accretive to earnings. As a result of i) healthy traffic growth, ii) expectation of fuel prices to remain lower for long, iii) return back to profitability and iv) disciplined industry capacity growth with less room for predatory pricing, there is scope for sector re-rate in the medium term.
Conclusion and final thoughts: We believe the sustained delivery of its financial and operational performance along with equity accretive balance sheet deleveraging from robust FCF generation makes Air Canada one of the most convincing investment opportunity.
Key risk to our thesis: i) volatile fuel prices, ii) high operating leverage from fixed cost structure, iii) economic slowdown and iv) competition leading to predatory pricing
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