RE:AIR CANADA VALUATION ANALYSISHello Again Logicandinertia,
Here are my responses to your comments, which are bold faced and in italics....
How is an airline valued? Typically EV/EBITDA or EV/EBITDAR (where R is aircraft rent). What does this mean? EV is Enterprise Value (Equity market value + net debt) and EBITDAR is an airline specific tool because it adds back aircraft rent (R), but also adjusts for leases in the EV. The EBITDA is earnings before interest, depreciation, taxes and amortization.
EBITDAR is no longer a financial measure for airlines. New accounting rules came into effect beginning in 2019. Please read the following link.
Resolving the Asset Dilemma
https://stockhouse.com/companies/bullboard/t.ac/air-canada?postid=30434233 So as at December 31, 2019, AC was valued at 4.5x EV/EBITDA, with total EV of $16.5 billion less net debt of $3.7 billion equaled the equity value of $12.8 billion (or $48.50 per share year end value). The EBITDA was $3,636 million. This 4.5x premium multiple (for an airline) was deserved given the many positive steps management had taken. An EBITDA of 4.5x is not a premium for airlines, at least not for North American airlines. Compared to its three counterparts in the U.S., Air Canada has traded at a significant discount over the years. In January of this year, Air Canada’s forward 12-month EV/EBITDA multiple was 3.9x while the average multiple of Delta, American and United combined was 5.5x, about 40 percent higher.
A couple reasons come to mind on why Air Canada traded at a discount. First, Air Canada did not have an in-house loyalty program. This changed in early 2019, but few analysts and most investors fail to fully appreciate the financial benefits of the new loyalty program. Read my
Aeroplan post from January 2, 2020 to get a better understanding of how Air Canada’s revenue generating capability has changed on the loyalty front.
https://stockhouse.com/companies/bullboard/t.ac/air-canada?postid=30509274 Importantly, Air Canada’s loyalty revenue is not tied to airline economics. And yes, current credit card spend is down, but that will change in the coming months. Air Canada is increasing its credit card subscriptions from 5 to 7 million over a three-year period, and up until the current crisis, was ahead of schedule.
A second reason, Air Canada execs made a conscious to grow economic profits rather than focus primarily on ROIC improvement. The link below provides some insight into differing strategies on this subject.
https://stockhouse.com/companies/bullboard/t.ac/air-canada?postid=30430077 In 2013, Air Canada began a $12+ billion wide-body fleet renewal program followed by a narrow-body renewal program, and as result, did not generate consistent free cash flow in the ensuing years because of the large annual capex spend. Healthy ROICs suffered through this process, a consequence of growth and new route development. To use McKinsey’s phrase, they took the burden of high capex spend up front. Read the following post entitled,
The Race for Efficiency: Burdening Capex as prerequisite for competitiveness. https://stockhouse.com/companies/bullboard/t.ac/air-canada?postid=30421725 The EV has now fallen to $8.9 billion (assume $18 share price), given net debt of $4.17 billion. National Bank assumes that AC burns $3.6 billion in 2020, so that would add another $3.2 billion ($3.6 billion less what they burned in Q1) to the net debt, which would end 2020 at $7.3 billion. According to the earnings call the number used by National was the upper limit. I would recommend using TD’s latest update, estimating an ending 2020 cash balance of $3.983 billion. Why? TD has much better insight into loyalty revenue, given TD is the primary partner in the loyalty program with Air Canada. However, no analyst is including the Boeing settlement, estimated to be about $1.1billion. The agreement was reached a short while ago, but was based on a June 30 ungrounding. The grounding has since been extended, and will likely involve additional compensation. It is
highly likely, that Boeing’s financial compensation this year will be in excess of $600 million, in addition to other in-kind considerations (e.g., free aircraft).
Another aspect that has to be taken into consideration is that the leasing costs under new accounting rules form part of the net debt calculation. Yesterday on the earnings call, it was announced that 79 aircraft were going to leave the fleet, either a trip to the desert or a return to the lessor. A quick review of end-2019 MD&A indicates that about half of the 79 aircraft will go back to lessors. Before COVID, the principal component of lease liability obligations between 2020 and 2023 was about $1.9 billion (Page 51, FY 2019 MD&A). With the removal of about 40 leased aircraft, expect to see a percentage of these obligations (and its impact on net debt) decrease at an accelerated pace.
Finally, most if not all airlines are working with their partner leasing companies, seeking either reductions or deferments in lease costs. For sure, expect to see lease renewals are much lower costs.
So, yes, net debt will increase over the next year, but not as much as one might think.
The airline is expected to shrink its capacity thru fleet reductions and its expense budget, so if we assume revenue can get back to $15 billion (about 2015 levels) on a run rate basis by mid-2021 (perhaps optimistic) and they generate an EBITDA margin just 200 basis points below 2019 levels of 19% –what would that imply for EBITDA? About $2.6 billion. As a side note, full year EBITDA margins have varied from 12.6% to 19.0% from 2014-2019 for Air Canada. The 2019 EBITDA margin is not a true measure of Air Canada’s cash generating capabilities, as the airline operated with nine percent of its fleet grounded. The airline incurred significantly higher costs (lease extensions at higher rates, higher maintenance costs, etc) while it was unable to capture its target revenue during its busy third quarter due to loss of capacity.
Furthermore, using previous year EBITDAR margins would be poor proxies. Why? More of the total fleet was leased, and a much larger percentage of the fleet comprised of older, less fuel efficient with higher maintenance costs. Moreover, until 2019, the airline did not have an in-house loyalty program.
How I would think about EBITDA margins in 2021 and beyond is as follows:
· Growing loyalty revenue independent of airline economy
· Network-wise, fewer direct flights and more connecting flights means lower cost
· Fewer leased aircraft means lower annual leasing costs
· New, larger aircraft have higher density seating, doing more with less
· Youngest fleet in NA with operating and maintenance costs
at least 10-12% lower than retiring aircraft
· Low fuel prices due to no 2019 hedges (most airlines hedged at higher prices)
· Return of six freedom traffic growth (stalled by Boeing MAX grounding) and likely to be more robust due weaker dollar and U.S. airline capacity reductions.
On the fuel piece, have a look at the significant reductions in fuel cost per seat mile in my post
From Good to Great: https://stockhouse.com/companies/bullboard/t.ac/air-canada?postid=30457384 If you don’t have time, here are the key points on fuel consumption:
Replacing the A319 fleet with the Boeing 737 Max 8 will result in a 36% reduction in fuel consumption per seat. Replacing the A320 fleet with the Boeing 737 Max 8 will result in a 27% reduction in fuel consumption per seat. Replacing the E190 with the A220-300 will result in a 28% reduction in fuel consumption per seat.
So using your assumption of $15 billion run-rate starting in mid-2021, I would argue that the airline is going to generate an EBITDA much higher than previously seen for the above noted reasons. I predict it will be
at least 22 percent.
The only other comment I would add is that based on my 35 years experience working at and with airlines, commercial executives typically are overly conservative when forecasting demand following recessions. (It must be part of their DNA.) I expect this to be the case this time too. Of course the upside of being too conservative is higher fares in the initial part of the recovery, until capacity catches up to demand. This too will contribute to higher EBITDA margins. And perhaps one of the changes in mindsets that all airline CEOs will adopt following this crisis is to keep capacity much tighter and fares higher than what has been the practice over the last ten years.
What multiple does one put on that figure? The low of 2.6x from 2015? Or 4.5x from 2019? Let’s assume 4x, closer to the peak than the trough. That means an EV of $10.4 billion. Based on my answer to your first point, my thinking is that Air Canada should be trading at a multiple similar to (5x to 6x) or possibly higher than what the U.S. carriers were trading at coming into the crisis. Likewise, the U.S. airlines should be trading at lower multiples than they have been. Why? Air Canada entered into the crisis with significantly higher liquidity, and has been much more nimble in reducing costs than its U.S. counterparts. To date, the U.S. majors have each accepted about $10B from their federal government in terms of loans, grants, etc. That assistance comes with strings attached, one being the inability to furlough staff until Oct 2020. The name of the game for 2020 is cash preservation. On the other side of this crisis, Air Canada should have lower net debt, compared to the U.S. legacy carriers, and with an industry leading loyalty program, a younger fleet comprising larger aircraft and higher density seating, much better operating margins.
Ultimately, to buy AC stock, one must think these assumptions are ridiculously conservative, but recognize that Air Canada’s EBITDA in 2018 (another good year) was $2.851 billion, just $200 million above that mid-2021 run rate figure of $2.6 billion. If you think that Air Canada can get back to within 10% of its prior peak EBITDA ($3.27 billion), despite a smaller fleet and fewer employees, and put 4.5x on that, less net debt of $7.3 billion, then the EQUITY VALUE would be $7.4 billion, or $27.46 per share. 2018 wasn’t such a good year. If you recall, oil prices reached $76 dollars that year, impacting earnings of all airlines. Air Canada was one of the only NA airlines to enter into this crisis without a hedge position on jet fuel. What do you think they will be paying for fuel over the next two years? That aside, based on what I presented above let’s use your assumption of a $15 billion revenue run-rate from the beginning of Q3 2021 to Q3 2022 (I believe it will be higher). Using my (conservative) 22 percent EBITDA margin, we get a 12-month EBITDA of $3.3 billion, about 10 percent lower than the 2019 value of $3.636 billion.
Using your EV/EBITDA multiple of 4.5x, we get an EV of just under $15 billion. Starting with your estimated net debt value of $7.3 billion, I subtracted the Boeing cash compensation and used TD’s end-year cash balance which better captures the loyalty component. This results in a net debt of about $6.4 billion which yields an equity value of $33/share.
If the market gives Air Canada a multiple similar to what the U.S. carriers were assigned going into the crisis (higher EBITDA margin, lower relative net debt), then we could see a share price closer to $40.
Isn’t it interesting that the BAY STREET analysts have targets around $20-28, and the share price has been oscillating between $14-20. The market is relatively efficient and had already figured this out. Personally, the scenario for the $11.48 target is likely more realistic, when you read the IATA, BOEING and other recovery forecasts. BAY STREET analysts want banking business from AC, so they can't be too pragmatic or pessimistic. Keep this in mind when you read the reports. But most are competent. If anything I find most Bay Street analysts overly conservative in their forecasts, and they typically only look 12 months out. Any long-term investor, doing their own discounted cash flow analysis is looking way beyond that as you know. As for markets, they are only efficient in the medium- to long-term. In the short-term share price is a lousy indicator of future success. Markets can be a
way off.
Finally I would not look to IATA or Boeing as a guide. IATA speaks for all airlines, in all regions and will naturally be conservative in their forecasts particularly when the airlines they represent are seeking significant financial support from their respective governments. Boeing operates on a different cycle than airlines do but even before this crisis, the manufacturer was dealing with other challenges that was impacting both narrow- and wide-body sales.
Cheers!