Analyze concerns from analyst community. Below exerpt is from one of the analyst reports.
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The Globe and Mail reports in its Saturday edition that if you catch them at the right time, airlines can deliver hefty gains. The Globe's John Heinzl writes that from the start of 2017 through the end of 2019, Air Canada's shares soared more than 250 per cent. Then COVID-19 hit, and the shares came in for a hard landing. Somewhat perplexingly, they have remained grounded for the last few years, despite a strong rebound in air travel since pandemic restrictions were lifted. In the third quarter, Air Canada's operating revenue surged 19.2 per cent to $6.3-billion and its operating income more than doubled to $1.4-billion. Yet, if the moribund stock price is any indication, investors remain concerned about the airline's rising labour and fuel costs, its $5.4-billion net debt load and the potential for higher interest rates to cause a slowdown in the economy in general, and air travel in particular. Yet another concern cited by analysts is that Air Canada's capital spending is projected to increase by $4.4-billion in 2025 and 2026 as it adds 18 Boeing 787-10 Dreamliners to its fleet. However, CIBC World Markets analyst Kevin Chiang sees a "disconnect" between AC's sluggish share price and its business fundamentals.
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Let’s analyze different concerns raised by analysts pertaining to AC’ potential to generate profit/cash flow for coming years.
Rising labor and fuel costs Labor cost increases have been direct cause of inflation, which over time will normalize (hopefully in next few months). The airline industry of 2019 had evolved from that of 2010. Industry had learned to manage capacity well, decreased their fixed cost proportion and increased flexibility (variable cost), which allowed them respond quickly to demand/business changes. The airline industry of 2023 is even better than that of 2019. Structurally, the industry has evolved further and managing capacity tightly allows them to keep yields high. Industry wide shortage of aircraft, MRO and other capacities makes the case stronger for higher margin/yield.
I have always maintained that oil price will hover around $80. In last 6 months it has fluctuated between 60s and 90s. AC (and other airlines) revenue model allows them to price their tickets to account for fuel price increases. As long as demand holds and capacity is managed well, higher fuel price is not an issue as it used to be. New generation aircraft are continuously reducing fuel cost per seat.
$5.4B debt A more meaningful metric will be leverage ratio, which is at 1.4, the industry best. As per the CFO (Nov 14
th: Scotia Bank Transportation Conference) their LR sweet spot is between 1-1.5. In 6 weeks from now, they will be somewhere in the middle of that range and their net debt should be<$5.0B. Further reduction is on the cards by end of Q1. Q1 is usually the strongest FCF quarter. Capital spend for 2024 is reasonable and will further deleverage AC to LR <1.0.
Total debt (including leases) is higher than pre-covid and demand destruction (if it happens; see economy section below) might slow the deleveraging process. The chances of this happening are minimal, as during recession, the demand destruction is the range of 10-15%. Even in that case, AC will produce substantial FCF and keep LR in the investors grade.
Higher interest rates There are negatives because of higher interest rates on the economy and demand. But the environment with 1) Constrained industry production and MRO capacity, 2) Lower airline capacity than 2019 combined with higher passenger demand (post 2019 GDP growth of about 15 percent) and 3) High immigration (travelers) will keep demand high enough for the current capacity, thus maintaining yields.
With > $9.5B liquidity in hand, and interest income very close to the interest cost (most of which at fixed rate), their Q3 net interest cost was $41M (~$165M for 12 months compared to $350M in 2019) With fast increasing FCF in coming Qs, even if interest rates begin to normalize (let’s say 2
nd half of 2024), we will continue to see lower range net interest cost. And ongoing debt and lease payments will keep interest charges in check.
Slowdown in economy/ air travel Under normal business circumstances, any slowdown in economy will reduce air travel. One major reason for this usually is reduction in business travel due to cost cutting in corporates. Leisure travel is not that impacted. Current situation is as follows: (Ref: Scotia Bank Transportation Conference Nov 14
th 2023):
- Corporate business demand is still at 70% of 2019 (a normal year). Corporates are indicating that business travel will continue to increase as more businesses have realized the need for in person meetings as management returns to their offices.
- Total demand is now trending few percentage points higher (as per CATSA) than 2019. But AC’s capacity is approx. @90% of 2019, allowing new players to step in for lower yield domestic travel. Competition will be intense in the lower yield market and some ULCC operators will likely alter than growth plans. AC will continue to focus on maintaining their margins.
- Immigration numbers are very strong. Since 2019, more than ~2M people have arrived in Canada and most of these do travel even if infrequently. The projected numbers for coming years are high, adding to more demand.
- China (South-East Asia) market is opening after a lull of more than 3 years. Till 2019, AC had 34 weekly flights to China and Hong Kong. Now they are adding Singapore and Thailand in their network. AC doesn’t have spare aircraft and hence will have to redeploy fleet from lower (relative) yield markets to China. Keep in mind, this year Atlantic market yield was amongst the highest.
Impact of Capex from 2024-2026 (better thank it looks?) See below the table for estimates of key metrics. These are based on information from RBC, CIBC analyst reports, CFO comments from 14
th Nov transportation conference, Q3 AC results MD&A and some of my estimates.
| Year | Revenue | EBITDA | @XX% of Rev | Cash flow from Ops | Capital Spend | FCF | Net Interest | Principle/
Lease | Net
debt | L Ratio |
| 2023 | $22.0B | $4.07B | 18.5% | $4.21B | $1.54B | $2.67B | $0.38B | $1,179 | $4.9B | 1.20 |
| 2024 | $23.4B | $4.56B | 20.0% | $4.93B | $2.59B | $2.34B | $0.16B | $887 | $2.82B | 0.60 |
| 2025 | $25.0B | $5.00B | 20.0% | $5.4B | $3.17B | $2.23B | $0.16B | $1,622 | $1.0B | 0.20 |
| 2026 | $27.0B | $5.67B | 21.0% | $6.12B | $5.14B | $1.0B | $0.16B | $2,740 | $0.70B | 0.13 |
Above calculation assume there is no share buy back or dividends. But, over next 3 years, AC will generate enough FCF (front loaded) to have the ability to give back up to $5.0B to shareholders and still keep LR ~ 1.0. And can repeat the same in the following 18 months. Also above calc does not take into account tax loss carry forwards in the coming years. Revenue: From analyst reports and my estimates. I believe 2026 number would be even higher. Based on points described earlier and new fleet (optimal range and efficient), the revenue numbers and yield are achievable. As per the CFO, current GDP is 15% higher than 2019 and AC capacity is 10% lesser than 2019. This has created a gap of > 20%, which will be filled over time. EBITDA: CFO in the conference (14th Nov 2023) mentioned that they are comfortable achieving ~19% EBITDA in 2023. In last investor’s day (March 2022) the target for 2024 was set for 19% margin. So far they have been achieving most of their targets ahead of schedule. And after narrow body fleet restructuring (2025), the margin will be 20%+. I believe this one metric is driving their strong focus on capacity management. Cash flow from Ops: 2023 numbers are based on YTD Q3 and estimated Q4 numbers. 2024 onwards, the Cash Flow from Operations EBITDA number is calculated as 108% of EBITDA. This number should be close to ~110% of EBITDA esp if the yields hold. For year 2027 it would be >110% because of young efficient fleet reducing the unit cost further. FCF: 2023 number is based on YTD Q3 and estimated Q4 numbers. To arrive at FCF, subtracted ‘Capital spend’ from ‘Cash Flow from Ops’. It is a very strong FCF story even with substantial capex. Note the lower net interest cost. The Air Canada forecasted 3 year (2022-24) FCF will be achieved by end of 2023. RBC forecast for 2022-24 FCF is $2.8B and AC has achieved FCF of $2.1B in first 3 Qs of 2023 alone and will continue the trajectory for next few years. Capital Spend: From Q3 results MD&A. It is money allocated for fleet purchase orders and others. 2025/26 Capital Spend is over stated (I have not reduced it for above calc) for 2025/26 as 15 321-XLR will be leased instead of purchase. The CFO said that approximately half the wide-bodies under consideration for replacement with the 787-10s are leased, and replacing these aircraft will result in a decrease in (total debt and) leasing obligations. Debt and lease payment: Scheduled debt and lease payments as per Q3 MD&A. Net interest: With high liquidity and high interest rates, net interest cost has reduced. In future, if interest rates come down, there is enough liquidity (>$5B excess) to start prepaying some of the higher interest rate debt. Conclusion AC is well poised to raise enough cash flow from operations to tackle the proposed capital spend and in addition, either further deleverage or return money back to shareholders. Raised concerns are exaggerated and are stemming from pessimistic view point.