I had written about the cost transformation and valuation rerating potential for Air Canada (OTCPK:ACDVF) last November 2015 when the share price was around USD10. My thesis was that the stock could easily be the best airline success story in 2016 as it was in the midst of a major turnaround phase with potential for multiple rerating. The company has shown a lot of operational and financial discipline with the management initiatives really paying off. However after the company released its FY 2015 results on February 17, 2016, the stock price has corrected ca. 18%.
We believe the two major reasons that can be attributed to the pullback are investors' concerns over its decision not to provide any guidance on monthly traffic, forward-looking quarterly and annual capacity information and ii) cash flow stress over the Bombardier CSeries order. In this article we will discuss as to why these investor concerns are misplaced and the significant upside return potential as part of its cost-transformation story.
1. Purchase of 45 CS300 aircraft bodes well for its long term strategy:Air Canada entered into an agreement with Bombardier (OTCQX:BDRAF) on February 17 to purchase 45 Bombardier's CS300 aircraft with an option to buy an additional 30 planes. Deliveries are scheduled between late 2019 and 2022 and the first 45 planes would cost ca. CAD3.8bn. We believe that the order size is slightly larger than what the street had expected and have raised concerns over the incremental capital and cash flow need to fund the purchase.
However, we believe that the deal to be positive for the long term and suits its cost transformation plan. The first 25 aircraft are aimed at replacing its current fleet of 25 Embraer E190's, while the remaining 20 would be used to support future growth. The induction of CS300 Series would generate significant amount of cost savings as they burn less fuel and have lower maintenance cost (on a per seat basis) that should lead CASM reduction of ca. 10% compared to its replacements. It would also add flexibility providing to deploy on long-thin routes in a cost effective way. The deal also comes with short term benefit with the Government of Quebec agreeing to discontinue the litigation related to Air Canada's obligations regarding the maintenance of an overhaul and operational center.
2. Air Canada has flexible aircraft capacity: Though Air Canada did not provide any capacity guidance for 2016, it has an flexible fleet with staggered expiry dates spread over several years. It has a huge base of owned and unencumbered assets that can be briefly or permanently removed from its fleet. It should be noted that Air Canada will outright own around 22 older wide-body and narrow-body aircraft and has another 18 narrow-body aircraft coming into books with leases getting over in late 2016 and 2017 that would help better match demand levels. Also, the new capacity additions planned are international routes with healthy demand serviced by low cost capacity.
3. Strong potential to improve FCF generation: Air Canada generated free cash flow of CAD197m in 2015 with operating cash flow of CAD2.0bn and capital expenditure of CAD1.8bn. The management had stated that it had spent CAD954 for financing aircraft purchase and the remaining ca. CAD900m for maintenance capex. This implies that Air Canada can generate FCF after maintenance capex at an annual run-rate of ca. CAD1.0bn that can be deployed in aircraft capex. This translate to a FCF per share of ca. CAD3.4, translating to a yield of ca. 47% based on share price of CAD7.2. As a result, investors should not worry about the upcoming high capex period. The aircraft induction would push down the fleet age to less than 10 year and make Air Cana fleet one of the youngest in North America. This would also help improve return on capital employed and lead to higher earnings and FCF generation base with the winding down of growth capex.
Conclusion and final thoughts: At these levels, the stock looks highly undervalued, trading at 3.2x EV/EBITDAR. This is a steep discount of 25% compared to peers and offers favorable risk-reward profile, despite being in the middle of a transformational turnaround that would be accretive to earnings. As a result of i) healthy traffic growth, ii) expectation of fuel prices to remain lower for long, iii) return back to profitability and iv) disciplined industry capacity growth with less room for predatory pricing, there is scope for the sector re-rate in the medium term.
Key risk to our thesis: i) volatile fuel prices, ii) high operating leverage from fixed cost structure, iii) economic slowdown and iv) competition leading to predatory pricing
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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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