Note from Tempo1: A sound analysis of the market reaction to Airlines headwinds. Is the current low price justified?
Putting Things Into Perspective
Our Conclusion
We see a disconnect between AC’s share price performance and fundamental outlook. Near-term demand trends are proving to be more resilient than feared while the increase in capex, which should have been expected given the 787-10 announcement back on September 25, does not jeopardize AC’s balance sheet. We maintain our $30 price target and Outperformer rating.
Key Points
Putting Things Into Perspective: While AC’s Q3 results exceeded expectations by a wide margin, we suspect the narrative on what has driven a 34% decline in its share price since July 3 has not dissipated. The bears’ argument would be that the strong Q3 was yesterday’s news with the market concerned about the weaker demand trends moving forward, impact from the global conflicts, and higher energy prices. These are not favourable headlines for airline equities (XAL Airline Index is down 40% in the same period). We recognize that when airline equities are facing negative sentiment, there is not much of a fundamental anchor. That said, we look to put into perspective the move in AC’s shares over the past four months
First, AC's EV is similar to what it was in November 2020, reflected in the recent decline of its market cap and its active deleveraging. While sentiment in the airline space is challenged today, it is hard to argue it is not better than it was three years ago.
Second, prior to the sell-off, AC was trading at ~4x EV to 2024E EBITDA. If we assume AC is still trading at this multiple but consensus expectations are too high, then this would imply a 2024E EBITDA of ~$3B. That would reflect a ~25% decline in our expectations. For context, the last time we saw this large a decline was back during the Great Financial Crisis (AC’s EBITDAR was down 41% Y/Y), but we would argue that AC is fundamentally a better airline today and the overall North American airline industry is more rational. In terms of the former, in 2007, AC’s leverage ratio was 4x and it had a FCF usage of $2.2B. While AC’s business model has had to adjust to a postpandemic world, we would note that back in 2019, AC had noted that it had stress tested its operating model and determined that EBITDA margin contraction would be less than half of the 500 basis point decrease it experienced in 2009, the year following the start of the Great Recession. It also contemplated other "black-swan events" such as 9/11, the tech bubble bursting, and SARS as goalposts. The implied decline in EBITDA margin would be ~500-600 bps assuming the current EV. This feels overly punitive given the last time we saw AC’s margins contract this much was in 2008 with the onset of the Great Financial Crisis.
Third, AC’s competitive positioning in Canada has created a wider moat. It is leveraging its hubs, which are also situated in Canada’s largest cities. Its fleet investments will extend its international reach while improving its unit costs, further securing its position as Canada’s leading global carrier. We believe there remains strong pent-up demand for international travel. For context, Pacific ASMs remain at ~57% of their 2019 levels, and AC noted that it is seeing strong opportunity to redeploy capacity into the APAC sector over the coming months, citing stable demand indicators. Net-net, we continue to view AC as a deep-value name with an underappreciated resiliency and growth outlook
Demand KPIs Remain Healthy: AC’s Q3 results and outlook continue to point to a healthy demand environment. While there remain concerns that a weakening Canadian consumer impacted by higher rates will result in a decline in AC’s booking curve, we have not seen this materialize in the company’s results. Load factors was 89.8% in Q3, a record high, while PRASM was up 11% Y/Y. Demand continues to outstrip capacity. AC is guiding to demand trends remaining strong and in line with expectations looking out through the winter season. While advanced ticket liabilities fell from $5.71B to $4.53B Q/Q exiting Q3, this reflects a more typical seasonal pattern. For reference, advanced ticket liabilities went from $3.73B in Q2/19 to $2.94B in Q3/19.
Capex Bump Is Manageable: Investor feedback has also pointed to concerns around AC’s revised capex outlook. We would note that AC announced its 787-10 order back on September 25, which includes a firm order of 18 aircraft and an option to exercise for an additional 12 aircraft. We would argue that this capex bump should have been expected. We suspect the main concern is that AC is adding aircraft, and there is a concern around the Canadian consumer. We think this ignores the following points. First, these aircraft are primarily for replacement reasons so the net capacity growth is not as large. Second, history has shown airlines have flexibility in their capex if they need to adjust their schedule. AC has done this in the past and we expect this to remain a lever available to them. Third, these aircraft are a strategic positive as this would secure AC’s position as Canada’s leading global carrier. It would improve unit-cost economics, open up new routes and drive increased sixth freedom traffic – all of these are accretive to margins. Lastly, AC can absorb this capex without jeopardizing its balance sheet. Looking at it simplistically, with its leverage ratio set to exit 2024 at ~1x in our view, the airline can prioritize its excess cash towards other initiatives. If we take AC’s current run-rate EBITDA of ~$4B, this equates to ~$8B in operating cash flow over two years. Total projected expenditures in 2025/26 is expected to be ~$8.3B. In other words, we are not fussed by AC’s fleet investment plans. While we recognize there is sensitivity to AC’s EBITDA depending on the macro environment, given the current strength of its balance, the company is in a position to absorb this capex.