Earnings Call Update and Five-Year FCF EstimateFollowing are my thoughts on comments made by Executives on the recent earnings call. Fleet and Capex From a fleet perspective, most, if not all, of the narrow body update will be completed by June in time for the busy summer flying season. The remaining nine Boeing 737 Max 8 aircraft will be delivered in the first half of 2022 and will be paid for with excess cash. The six remaining Airbus A220s will also be delivered in 2022. Three of the six were financed under March 2021’s secured facility for fifteen aircraft totalling US$475 million. It is likely the remaining three aircraft will also be paid out of excess cash. The Company also announced the firming up of twelve additional Airbus A220s, six to be delivered in 2024 and six in 2025. The twelve were part of the original order of 45 aircraft. Five older narrow body aircraft will exit the fleet this year. Finally, the first of three Boeing 787-9s will be delivered this year, the remaining two in 2023. Again, it is likely these aircraft will be paid with excess cash on hand.
From a Capex perspective, the MD&A indicates committed capital expenditures (aircraft) for 2022 is $1.15 bn. Capex may be less. The estimated acquisition cost for the 16 deliveries (nine B737 Max’s, six Airbus A220s and one B787-9) in 2022 is about $950 million. As mentioned in previous posts, however, a large component of the Boeing 737 Max settlement involves in-kind consideration, mostly aircraft, but parts as well, in addition to a smaller percentage in cash that was paid to Air Canada in 2019. The settlement is estimated to be in the $1.1 bn range.
In comparing 2021 Q3 and Q4 aircraft deliveries against quarterly capex – seven Max’s were delivered – it appears that the Company paid for some of the aircraft but not all. This suggest that all or most of the remaining nine Max aircraft to be delivered in first half 2022 may come at no cost to the Airline, forming part of the ‘in-kind’ consideration. If this is the case, then MD&A capex for 2022 is overstated, and analysts’ free cash flow estimates will be understated. Another possible explanation is that capex spend is accurate and includes yet to be announced aircraft purchases.
Operating Leverage Coming Down Entering the Covid-19 crisis, the CEO/CFO took steps to lower operating leverage, reducing the Break-Even Point, ROIC volatility and total risk. Operating leverage continues to come down as new fuel-efficient aircraft with lower operating costs are replacing older, leased aircraft.
Sound Strategy for Lowering Financial Leverage Weighted average interest rate is 3.91 percent (after tax cost of 2.9 percent) and an extended debt repayment schedule is in place. Between 2022 and 2024, the average principal repayment is $550 million, increasing to $1.78 bn in 2025 and $2.37 bn in 2026. Through planned principal repayment and decreasing lease liabilities, Air Canada’s long-term debt and lease liabilities will fall from the current $16.5 bn to $8.57 bn at year-end 2026. Even with excess cash levels (currently about $9.3 bn) coming down, a growing EBITDA will still put Air Canada into investment grade territory in 2025.
Cash Management Executives are deciding how much cash should be carried on the balance sheet going forward, in view of their experience with Covid-19. Traditionally, a good rule of thumb for airlines was to carry about 20 percent of annual revenue in cash/cash equivalents. There were always exceptions in the industry; for example, Delta carried about 8 percent of total revenues in cash/cash equivalents, along with established lines of credit.
Prior to Covid, Air Canada carried about 20 percent of revenue in cash/cash equivalents; however, the CEO suggested on the earnings call the airline may move away from a revenue percentage to one based on cost structure along with (increased) lines of credit. The CEO also commented that the current cash level was much higher than what is needed going forward.
Part of the excess cash was used to call the approximately 7.3 million warrants that vested when Air Canada and the Federal Government entered the financing arrangement in first half 2021. These warrants were re-purchased for $82 million last month and subsequently cancelled. The other 7.3 million warrants remained unvested throughout the financing arrangement.
With highly efficient debt and an extended debt repayment schedule, the CEO indicated that “we are very, very comfortable to take our time to find the best possible opportunities to deploy our cash.”
Five-Year Estimated Free Cash Flow $ Billions
2022: 0.5 to 1.0+
2023: 3.0 (company should meet/surpass 2019 EBITDA on lower revenue than 2019)
2024: 3.6 (see last post, Vagaries of Value Creation, and six Airbus A220s)
2025: 3.8 (growth due to Loyalty, Cargo, and six Airbus A220s)
2026: 4.0 (growth due to Loyalty and Cargo)
Total: 15.0 bn in free cash flow, over five years
Less: 5.8 bn principal debt repayment
Less: 2.0 bn net interest charge
Net: Approximately $7 bn in free cash flow available for investment opportunities.
So, what could these opportunities be?
- Share buybacks
- Acquisition of Airbus A321 LR aircraft
- Acquisition of the airline component (Jazz) of Chorus Aviation
- Investments in other businesses
Future Share Price Appreciation Key points to consider for Air Canada’s share price appreciation in the next two to three years:
1. Like what occurred starting in 2013 with the U.S. airlines (see below for two examples), Air Canada should begin to see
meaningful share price appreciation as the airline’s ROIC rises again above its cost of capital, in the coming quarters, re-links with its current EV/IC multiple and begins pulling the valuation multiple higher as return on capital continues its climb.
2. In the three-year period (2013-2015), the US carriers experienced significant increases in market capitalization in the
first two years from the time ROIC exceeded its cost of capital.
3. While Delta and Southwest achieved this market cap appreciation with older fleets and essentially unchanged invested capital bases in this three-year period, Air Canada will operate in the coming years with a young fleet, and a still growing capital base, about 5-7 percent annually ($1.0 to $1.2 bn/$14 bn).
4. Like Delta, Air Canada will see higher free cash flows than would normally be the case, due to tax loss carry-forwards.
5. Expect growing loyalty and cargo revenues and margins to be increasingly significant contributors to Air Canada’s free cash flow story going forward.
Delta Following its merger with Northwest in 2008, Delta’s focus at the time was to deleverage the balance sheet, achieve an investment grade rating and grow ROIC into the 20 to 25 percent range. Between 2009 and 2012, Delta’s ROIC averaged 10 percent, about its weighted average cost of capital. During this three-year period its share price was range bound between $4 and $14 but averaged $9. In this same period Delta’s leverage ratio decreased from 8.2 times in 2009 to 2.8 times by the end of 2012. In 2012, Delta’s ROIC was one percent higher than its cost of capital (11 percent ROIC, 10 percent wacc), and the airline was trading at an EV/IC multiple of just over 0.9 times.
Delta’s share price appreciation began about the same time as its ROIC exceeded its cost of capital. Entering 2013 Delta’s market capitalization was about $11 bn. ROIC rose to 15 percent in 2013, 20.7 percent in 2014, and 27 percent in 2015. The jump in 2015 ROIC was the result of a 43 percent reduction in fuel costs. Adjusted for lower fuel costs, YOY ROIC remained about the same. Free cash flow increased from $2.1 bn in 2013 to $3.8 bn in 2015, with free cash flow as a percentage of total revenue averaging 8 percent during this period. What helped Delta generate higher free cash flows over this period were net operating loss carry forwards, about $3 bn annually.
From 2013 to 2015, Delta’s invested capital remained at about $25 bn. By year-end 2014, Delta’s 20.7 ROIC had increased its EV/IC to about 1.90 times. Debt reduction in 2013 and 2014 was about $4.5 bn, and its leverage ratio was below 2.0 times. As ROIC rose over this period, so did Delta’s market cap. In 2013, the airline’s market cap more than doubled ($25 bn) and by year-end 2014, reached a high of $40 bn, averaging out at $38 bn from that point on as Delta’s capex program began to accelerate into 2015 and beyond. Shares outstanding in this period averaged 835 million.
Southwest Airlines Southwest’s story is a similar one to Delta’s as it relates to ROIC improvement. Southwest enjoyed a strong balance sheet, so debt reduction was not a factor in the airline’s turnaround. In 2012, Southwest’s ROIC was 7 percent, just below its 8 percent cost of capital, and the airline’s EV/IC multiple was 0.7 times. In the previous two years, its share price was range bound between $8 and $12. Like Delta, Southwest’s share price appreciation began about the same time as ROIC exceeded its cost of capital.
Southwest saw its ROIC increase to 13.1 percent in 2013, 21.2 percent in 2014 and 32.7 percent in 2015. Like Delta, the significant jump in 2015 ROIC was largely the result of a significant decrease in oil prices. As ROIC improved, so did free cash flow, jumping 44 percent in 2013 from its 2012 level. Free cash flow as a percentage of total revenue averaged 5.7 percent over the three-year period. By year-end 2014, the much higher 21.2 percent ROIC increased Southwest’s EV/IC multiple to 2.4 times. During the three-year period, Southwest’s invested capital remained in the $12 bn range. Southwest’s market capitalization increased from $7.9 bn at year-end 2012, to $13.6 bn at year-end 2013, to $29 bn year-end 2014. Market cap fluctuated throughout 2015 but ended the year at $28 bn. Shares outstanding in this period averaged about 700 million.
Summary Given Air Canada’s financing needs have been met for the medium- to longer-term, its current rate level sub-four percent and access to enhanced equipment trusts in future years at favourable rates (comparable to investment grade), an accelerated path to an investment grade rating will have little, if any, impact on share price performance. In view of expected free cash flow generation and share price performance going forward, and possibly better than expected share price appreciation in the next two years, the Company may begin a share re-purchase program sooner than many investors are anticipating.
Assuming $4 bn of the $7 bn in free cash flow generated over the next five years is used for share buybacks, say at an average purchase price of $60, total shares outstanding could fall by as much as 65 million, putting total share count much closer to pre-covid levels.