Summary
- Air Canada blew away estimates and produced another record profit.
- This follows a long turnaround at the airline that saw it go from near-bankruptcy to fat profits.
- With the turnaround still on track shares appear deeply undervalued.
On November 5, Air Canada (OTCPK:ACDVF) released its Q3 2015 report and its follows in a pattern of record profits for the airline. Shares soared 6.5% as earnings blew away estimates as this report is yet another sign that Air Canada has moved beyond its former distressed self and into a new era of fat profits.
Despite the post earnings rise, shares remain in the bargain bin and have lots of room for upside.
source: Air Canada
Report analysis
For Q3 2015 Air Canada reported adjusted EPS of $2.50 beating expectations of $2.23 and representing a 61% year-over-year increase. Alongside these earnings Air Canada also reported a strong 20.3% operating margin for an improvement of 6.5 percentage points.
The most obvious driver of this increased performance was the sharp drop in fuel prices that reduced Air Canada's fuel expenses by $477 million year-over-year. However, this was partially balanced out $215 million in capacity growth and unfavorable currency impacts. Also helping the airline was a 6.9% increase in revenue driven by a 10.5% capacity increase primarily through international expansion.
The much watched PRASM figure also declined 4.0% year-over-year largely due to lower yields. While PRASM declines are a general negative, this decline was more than balanced out by lower fuel costs and expansion. Air Canada's business strategy is also likely to cause PRASM to decline since Air Canada is expanding its discount Air Canada rouge subsidiary, packing seats tighter utilizing "high-density" configurations, and increasing capacity growth 9.0% to 10.0% year-over-year. Overall this strategy has been a profit growth driver for the airline so I do not see the PRASM decline as a major issue.
Valuation and upside
One may expect that an expanding company reporting sharply higher record profits would carry a high stock valuation; however, this is not the case for Air Canada. Shares currently trade at only 4.0x est. 2015 EPS, 3.3x est. 2016 EPS, and 2.6x est. 2017 EPS pricing Air Canada as a company going out of business.
This valuation also makes Air Canada much cheaper than its U.S. based rivals which already trade at low valuations and well below the 8.2x est. 2016 EPS valuation given to WestJet Airlines (OTC:WJAFF).
Looking at Air Canada's growth profile I believe an 8.0x EPS valuation could be appropriate next year. Based on the 2016 EPS estimate of $3.34 this would put shares at $26.72 for upside of 130%. Even taking a 5.0x EPS valuation, similar to those of American Airlines Group (NASDAQ:AAL) and United Continental (NYSE:UAL), Air Canada shares could trade at $16.70 for upside of 44% from the current trading price.
Potential catalysts for a valuation boost include a shift in investor attitudes as Air Canada continues to perform, a boost to the share buyback program, or the initiation of a dividend.
Risks
Despite the turnaround at the airline there still are risks that investors should keep in mind. Besides the classic airline risks, Air Canada also faces currency risk as a lower Canadian dollar increases the costs of aircraft rents/leases, U.S. dollar denominated debt service, and fuel costs. However, the currency issue is partially hedged by the Canadian dollar being closely tied to fuel falling alongside lower oil prices and rising alongside higher oil prices.
Air Canada is also at risk if the Canadian economy slows and hurts consumer demand. Lower oil prices have pressured Canada's oil producing regions and caused economic growth to slow. However, Air Canada seems to be handling these economic concerns with CEO Calin Rovinescu saying "Even if we were in what the Bank of Canada deemed a recessionary environment, people were still traveling." Additionally, international expansion is helping to diversify Canada away from the Canadian economy.
Air Canada takeaway
Even after reporting another batch of record earnings Air Canada shares still trade at just over three times forward earnings. I remain bullish on the airline's shares and I encourage deep value investors to take a further look themselves.
Disclosure: I am/we are long ACDVF, AAL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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