Looking Back From a Leap Forward into The FutureCompensation will be much more than the earlier estimate of $907 million. Not included in my previous estimates are last year’s wet-leasing costs, lease extension costs and aircraft storage costs. The loss in U.S. dollar sales resulting from the inability to grow sixth freedom flying also impacted negatively on the Airline’s foreign exchange risk management program. I assumed at least some of these were included in the cost per seat mile, but that is not the case.
In its February 18
th financials, Air Canada stated 2020 maintenance costs are expected to increase by approximately $150 million. Some of this increase is the result of older aircraft on lease extensions undergoing required airframe checks and engine overhauls. Heavy airframe checks are in the millions of dollars and require about five weeks downtime (and loss of incremental revenue). Engine overhauls are also expensive, mostly due to the cost of components, priced in USD. The cost of these checks will be recovered from Boeing.
Also, I did not account for the salaries of the grounded pilots. I assumed the cost of grounded pilots was included in the cost per seat mile, but again this is incorrect. Most airlines are not including this cost in their seat mile cost. Using Southwest’s crewing ratio of 6.2 crews (12.4 pilots) per 737 aircraft (obtained from MIT airline data), and with 24 aircraft grounded, Air Canada should have approximately 300 pilots grounded. Total grounded days in 2019 were 293, and grounded days in 2020, assuming a re-certification date of end-June, will be 213 days (assumes a two-month start-up averaged out to August 1st) for a total of 506 days or 1.39 years.
If we assume the
average total compensation (salary, pension, overtime, and other benefits) for each pilot is $220,000 (Captains paid more, first officers paid less) then the additional cost is about $92 million (300 pilots x $220,000 x 1.39 years).
The cost of grounded pilots plus the additional costs, particular maintenance checks, mentioned above pushes my earlier estimated compensation of $907 million to well over $1.0 billion, and much closer to $1.1 billion. Given the partial payment in 2019, this leaves about $800 million of additional compensation coming to Air Canada, this year and next.
As reported on February 18, the compensation is accounted for as an adjustment to the purchase price of current and future deliveries and will flow through Air Canada’s consolidated statement of operations as reduced depreciation expense over the life of the aircraft, and as a reduction to additions to property and equipment on the consolidated statement of cash flow.
The final compensation agreement with Boeing will not be finalized until the MAX is re-certified.
Now let’s figure out what Air Canada is up to.
Capex Discrepancy On Page 32, Q3 2019 MD&A (October 29, 2019), Air Canada lays out its 2020-2023 projected committed expenditures. These are new aircraft purchases. The document also includes a table (Page 21) showing fleet additions for 2019 and 2020. Listed below are the capital expenditures for 2020-2021 and fleet additions to December 31, 2020. (All capex numbers below are in millions of dollars.)
2020 2021 Capex 2,281 741
737 MAX 26 0
A220-300 17 16 (Note 2)
Notes:
- As of Q3 2019, Air Canada MAX fleet consists of 24 aircraft with the remaining 26 planned for 2020. In a previous post, it was mentioned the remaining 11 firm orders (MAX 9) are delayed. These aircraft are not shown in the fleet tables.
- From the Full Year MD&A (below) we learn 16-A220s are planned deliveries for 2021; and it can reasonably be assumed the 2021 planned capex of $741 million is for these 16 aircraft. This implies a cost of $46.3 million CAD per fin ($741 million/16).
For the 17-A220s acquired this year, the total acquisition cost is $787 million (17 x $46.3 million). Subtracting this value from the total 2020 capex spend of $2,281 million leaves $1,494 million ($2,281 million - $787 million) for the purchase of 26 MAX aircraft, or $57.5 million CAD per fin based on the September 30, 2019 closing exchange rate (US$1=C$1.3241). These numbers vary from quarter to quarter depending on the exchange rate. Using the December 31, 2019 closing exchange rate (US$1=C$1.299), the cost of one MAX aircraft is now $56.4 million CAD. I assume the MAX purchase agreement was in USD, and the A220 purchase was in CAD (both Canadian companies at the time the agreement was reached).
On Page 50 of the Full Year 2019 MD&A (February 18, 2020), Air Canada lays out its
revised 2020-2023 projected committed expenditures, and the fleet table (Page 39) now gives us visibility into 2021
planned additions.
2020 2021 Capex 1,635 1,532
737 MAX 6 20
A220-300 17 16
Using these aircraft cost estimates and applying them to the planned fleet additions for the next two years, the capex spend
should be as follows:
Year
2020 2021 6 - 737 MAXs 338
20 - 737 MAXs 1,128
17 - A220s 787
16 - A220s 741
Total Capex Spend (committed) 1,125 1,869
From the above, it can be seen that an inconsistency exists between planned committed expenditures and the fleet additions this year and next.
Looking at this year, Air Canada indicates only 6 MAX aircraft are planned to be delivered later this year; yet, the Company has recorded a capex spend $610 million more than is necessary ($1,635 million - $1,125 million = $610 million). Likewise for 2021, the Company indicates capex spend will be $1,532 million when it should be $337 million higher ($1,869 million - $1,532 million).
Here is my thinking on this:
In the first six months of
2018, Air Canada took delivery of 16-MAX aircraft (Q2-2018 MD&A), at the rate of 2.67 aircraft per month. So, assuming the MAX is re-certified end-June, the current 24 are re-integrated into the fleet by end-August, and deliveries resume in September, the Airline could take delivery of up to 11-737 MAX aircraft. Let’s assume 11 aircraft.
Given Air Canada would want to resume six freedom growth as soon as practicable after the MAX is re-certified, it seems unlikely they would only take six aircraft when at least 11 could be absorbed into the fleet by end-year. Doing so would allow the Airline to take delivery of the final 15 fins by end-June 2021, just in time for the busy third quarter. Therefore, I believe the plan is to take more than six MAX aircraft this fall, and the $610 million discrepancy in 2020 capex spend is an indication the Airline is accounting for this amount of compensation from Boeing in 2020.
From my February 2
nd post, we learned Boeing’s compensation package will include cash and other in-kind concessions. Also, with the revised estimated total cost to Air Canada now at $1.1 billion, of which $300 million has already been received, $800 million has yet to come to the Airline.
OTB mentioned in a Stocktwits post that we don’t know how Air Canada is going to receive its compensation from Boeing and what the tax implications are. Obviously, the Company will want to achieve the best outcome tax-wise. It is also likely they will want to take as much compensation as possible in the same year the MAX grounding impacts earnings the most, and that is this year. Additionally, having more free cash flow sooner allows the Company to re-purchase shares at lower prices. Since a $600+ million discrepancy exists this year in capex spend vs fleet additions, let’s assume the full amount is applied this year in aircraft discounts.
Using the MAX cost of $56.4 million per fin, all 11 MAX aircraft ($56.4 million x 11 = $620 million) would come to Air Canada later this year, all part of the 2020 compensation package. This substantially reduces Air Canada’s committed capex spend in 2020 to just 17-A220s ($787 million). The remaining approximately $200 million in compensation would be applied as a discount to 2021 MAX deliveries.
Based on these assumptions, a more realistic capex spend for 2020-2021 would be as follows:
Year
2020 2021 11 - 737 MAXs 0
16 - 737 MAXs 902
17 - A220s 787
16 - A220s 741
Less: 2021 Compensation (200)
Total Capex Spend (committed) 787 1,443
Adding the projected planned but uncommitted expenditures and projected planned but uncommitted capitalized maintenance expenditures (Page 50, FY MD&A) to these numbers yields the following 2020 and 2021
total projected expenditures:
2020 2021 Projected committed exp. 787 1,443
Projected planned but 484 633
uncommitted exp.
Projected planned but 317 456
uncommitted capitalized
maintenance
Total projected expenditures 1,588 2,532
Last year’s operation generated an EBITDA of $3,636 million. Net cash flow from operating activities was $4,100 million, $464 million above EBITDA.
Using RBC’s February 18
th consensus data, EBITDA for 2020 is estimated at $4,008 million, which should generate net cash flows from operating activities in excess of $4,400 million. Even if we conservatively assume the same net cash flow from operations this year as last year (coronavirus impact worse than expected), this would still produce a free cash flow of $2,512 million ($4,100 million - $1,588 million). And even if half of the $600 million in expected compensation is in discounts and the other half in cash (and taxable), free cash flow should still be over $2,400 million.
For 2021, RBC consensus EBITDA is $4,541 million. This should generate a net cash flow from operating activities of about $4,900 million. Given my revised estimated total projected expenditure of $2,532, free cash flow in 2021 should be at least $2,368 million ($4,900 million - $2,532 million).
Summary From what has been presented above, the following is highlighted:
- The agreement with Boeing will not be finalized until the MAX is re-certified.
- The company will minimize taxes paid in determining how the compensation will be received (cash vs discounts, etc.).
- It appears Air Canada has accounted for $610 million this year in compensation in its capex spend.
- Air Canada’s CEO/CFO have historically provided free cash flow guidance that is overly conservative.
- Free cash flow for 2020 should comfortably exceed $2,000 million, meaning Air Canada will meet its three-year free cash flow guidance in the first two years.
- Free cash flow for 2021 should also exceed $2,000 million, without any Boeing compensation included.
- Free cash flow over the period 2019 -2021 should exceed $6,000 million, considerably more than the Company’s guidance.
Closing Thoughts The intrinsic value of a company is a function of three variables: its capacity to generate cash flows, its expected growth rate in these cash flows, and the uncertainty associated with these cash flows.
In the case of Air Canada, its leverage ratio is under 1.0 and so its financial risk is low. An investment grade rating is imminent and so the cost of capital (discount rate) will be lower than it is today. So the only other risk is the uncertainty in its cash flows, and I have hopefully shown that a very high probability exists the Airline will generate healthy free cash flows going forward, much higher than their guidance suggests.
What is presented above is what many of the buy-side analysts are looking at, particularly hedge funds with airline expertise. As a retail investor, don’t be pre-occupied by accounting earnings. The intended audience for financial statements are banks, not investors. Focus on the free cash flow generating capability of the Company. I believe it is Air Canada’s intention to generate
annual free cash flows in excess of $2,000 million going forward.
The purpose of the margin of safety is to render the forecast unnecessary. Benjamin Graham