2019 Earnings Potential and Boeing B787s In an earlier post, I mentioned that a handful of airlines had reached agreements with Boeing for 2019 damages resulting from the MAX grounding. Air Canada has not issued a public statement on a settlement; however, one cannot infer that an agreement hasn’t been reached for 2019 damages.
Boeing wanted to incorporate some of the compensation to airlines into its 2019 year-end results, and given late year time constraints likely approached airlines with larger MAX fleet counts, Air Canada being one of them. One reason Air Canada’s management would be motivated to take partial compensation in 2019 is to make more free cash flow available sooner so the Company can re-purchase additional shares at lower prices. Of course, there may be valid financial reasons for the Airline to defer cash settlement until 2020.
Let’s assume that the Airline did negotiate a 2019 settlement and calculate how this might play out in their financials, target share price calculations and free cash flow guidance.
First let’s review what other airlines reported:
- American Airlines reported in January that it did not expect any material financial impact of the agreement to be realized in its fourth-quarter 2019 earnings, further stating that the compensation would be received over several years. So, it seems that the airline is taking most or all of its compensation in future concessions on aircraft acquisitions and possibly maintenance parts.
- Southwest Airlines in their FY 2019 earnings stated that the estimated damage to 2019 operating income was $828 million. The airline also mentioned that it had reached an agreement on compensation for 2019 damages.
- Turkish Airlines’ reported settlement is $225 million (USD) comprising $150 million in cash, and $75 million in other in-kind considerations, a breakdown of 66.67% cash and 33.3% ‘other’.
It is clear from the above reports that while Boeing may have a preferred formula for settlements, the manufacturer is also flexible in dealing with each airline’s preferred manner of settlement.
In examining Southwest’s 2019 free cash flow calculation, the airline shows a one-time cash infusion (not shown in previous years) of $400 million under the heading “Supplier Proceeds”. This is likely the after-tax cash payment from Boeing, a ‘supplier’ of aircraft. Applying Turkish Airlines’ reported breakdown for its 2019 settlement to Southwest’s estimated reported damage, the cash component would be 66.7% of $828 million or $552 million. Using Southwest’s effective tax rate of 23% (Capital IQ), the estimated after-tax addition to free cash flow would be $425 million, close enough to the stated $400 million.
In my January 8 post, I calculated the estimated impact on Air Canada’s 2019 operating income to be $395 million. Applying the Turkish Airlines’ breakdown to this amount is $263 million ($395 x 66.67%). The after-tax contribution to free cash flow would be $192 million ($263 x 73%). Air Canada’s most recent free cash flow guidance for 2019 is $1.3-$1.5 billion, so revised guidance would be $1.5-$1.7 billion.
Next, let’s look at earnings. Recall from the previous post, the argument was made for using the diluted earnings estimate of $6.75 because it captures the increase in 2020 net income and free cash flow resulting from the Boeing compensation. Using a forward 10.6 multiple, the target share price was $71.55.
The following is the estimated 2019 net income broken down into quarters. (The Q4 estimate is from Capital IQ.)
Q1 2019: 345
Q2 2019: 343
Q3 2019: 636
Q4 2019:
84 (est) (271 million shares)
$1.408 billion (est)
Diluted EPS: $5.20
Based on estimated 2019 earnings, and applying the forward 10.6 multiple produces a target price of $55.12
Adding $192 million to Q4 earnings, increases 2019 Q4 earnings to $276 million ($84 m + 192 m) and full year earnings to $1.6 billion ($1408 m + 192 M) and raises the estimated 2019 diluted EPS to $5.90.
Applying the same forward looking 10.6 multiple yields a target share price of $62.54.
Since we are fewer than 10 days away from 2019 earnings release, let’s look at the trailing 12-month multiple. Based on Friday’s closing, it’s trading at an 11.3 multiple but the TTM diluted earnings is $4.01. Q4 2018 was a $231 million loss. Q1 2019 was a $345 million profit. Applying this
trailing multiple to the upcoming most ‘recent’ four quarters raises the estimated EPS to $5.20 and if Boeing compensation is included, $5.90. Applying the current TTM multiple of 11.3x:
EPS $5.20, Share Price $58.76
EPS $5.90, Share Price $66.67
Of the analysts covering Air Canada, Helane Becker of Cowan has the highest (12-month) target price of $67.87. (Most of the other analysts are in the mid- to high $50s.) Based out of New York, she covers the U.S. and Canadian airlines. Her company also covers Boeing, and going into 2019 the manufacturer was Cowan’s top pick with a target price of $460 USD. Although I don’t have access to her reports I suspect she has considerable insight into the financial impact the MAX grounding is having on Boeing and an accurate picture of the compensation that Boeing will pay to airlines, and this is helping her in forecasting the higher target price for Air Canada.
Boeing 787s In a previous post (Gotta Get a few 737 Max 8’s NO CHARGE, Feb 6) JJWilson commented that it will be wide-body Boeing 787s and not MAX 8s as compensation. This is certainly a possibility.
On January 29
th, Boeing announced that it’s reducing production of the Boeing 787 due to lower demand. The production cut is largely the result of wide-body orders drying up from Chinese carriers during the US-China trade dispute although this could change due to the recent trade agreement between the U.S. and China, and China’s agreement to buy more American products. There are however other Asian carriers that are under intense competition or are experiencing currency challenges and have cancelled orders for the B787. Last October, Russia’s Aeroflot also cancelled an order for 22 Boeing 787s, some that were to be delivered this year. At the time, one Boeing insider speaking to a news organization, on the condition of anonymity, said that Boeing has dozens of unsold 787s scheduled for production in 2022. So, it’s reasonable to assume that Boeing is motivated to find a home for some of its B787s.
OTB has commented on other possible outcomes as well. As OTB mentioned in the same thread, there is uncertainty around the 11 Max 9 orders. With the Airbus 220 now in the fleet, the Airline has better data on its performance, a more up-to-date understanding of the U.S. market, and with recent purchases of early to mid-life A321s (not to mention the pending Air Transat merger, A321 NEOs and NEO LR aircraft) there may be no need for the MAX 9 or MAX 10. Perhaps it now makes sense to exercise Airbus A220s options instead (much lower acquisition cost).
In my Feb 2
nd post, I estimated the other in-kind consideration was $340 million. In the Q2 2016 MD&A, Air Canada recorded a sale-leaseback transaction for two B787s for $351 million. The Airline also recorded a gain on the sale of assets of $19 million. (The B787s were purchased in 2005.) Given Boeing’s production challenges it is possible for the in-kind consideration to be two B787s likely with discounts on additional B787s. We may not know the outcome for some time, but these are certainly interesting times.
One key to an airline’s long-term success is the opportunistic purchase of aircraft – new and used – at significant discounts.
Looking forward to February 18, 2020!