On Last Week’s Share Offering A monk enters a teahouse and states: “My master taught me to spread the word that mankind will never be fulfilled until the man who has not been wronged is as indignant about a wrong as the man who actually has been wronged.
The assembly is momentarily impressed.
Then Nasrudin speaks: “My master taught me that nobody at all should become indignant about anything until he is sure that what he thinks is a wrong is in fact a wrong – and not a blessing in disguise!”
This story conveys a ‘truth’ that all of us have experienced at one time or another.
And judging by comments on this board during the week, it appears that some ‘investors’
are disappointed with Monday’s announcement of an offering that will see a further dilution in shares outstanding. But wise investors know that what may at first appear to be a wrong,
is actually a calculated, well thought-out, longer-term play on the part of the Leadership that will lead to not only higher share prices but also healthier earning streams better insulating the Company from future economic shocks – it may truly be,
a blessing in disguise! After all, as the President and CEO once commented, he
is working for long-term investors, both retail and institutional. Short-term investors
are welcome to leave.
According to the Short Form Prospectus issued last Monday, net cash burn guidance has been revised upwards for Q4 from $1.1 billion to $1.3 billion in the Q3 Outlook to between $1.4 billion and $1.6 billion. The increase in cash burn results from lower-than-expected travel bookings in Q1 2021, and the timing of cash receipts from various sources now expected to be received in H1 2021. One major cash receipt the Prospectus is likely referring to is the sale and leaseback in early October of nine Boeing 737 MAX 8s for total proceeds of US$ 365 million ($485 million), delivered in the past three years. The MAX was grounded at the time, and with the timing of the ungrounding uncertain, it is likely that the deal would only become effective after the MAX was re-certified.
At the end of Q3, Air Canada’s total cash, short and long-term investments, and restricted cash was $8,275 million. Including cash from the offering ($815 million), total cash is now $9,090 million. Net cash flows from operating activities in Q3 was $(286) million. If we adjust this upwards by $(200) million to account for lower-than-expected travel bookings in the next Quarter, estimated net cash flows from operating activities in Q4, will result in a reduced cash balance of $8,604 million ($9,090 million - $486 million). Fourth quarter capital expenditures are $312 million, and long-term debt and lease liabilities are $257 million (from Q3 MD&A). This further reduces year-end cash levels to $8,035 million ($8,604 million - $312 million - $257 million). (The stronger Canadian dollar in Q4 will favourably impact end-year long-term debt and lease liabilities.)
So, with the offering, expected cash levels at end-year should be approximately $8,000 million. Even without the offering, expected cash levels at end-year would be about $7,000 million, a comfortable level at this point in the crisis, particularly with an additional $485 million set to arrive in Q1, now that the MAX has been re-certified in Canada. The more than adequate cash levels suggest something else is in play and unknown cash outlays are occurring in Q4 and possibly into Q1.
Here is my take on Monday’s share offering. It appears that Air Canada and the Trudeau government reached a stalemate in their discussions for financial support, and with no further progress being made, Air Canada executives, likely time constrained with several strategic imperatives, decided to move on using other forms of financing.
Coming into this, the Trudeau Liberals’ initial position would be similar to most other countries that provided financial support to their airlines. Federal support in the form of an equity infusion and, in return, airlines would have to refund monies paid for tickets, forego share buybacks and dividend payments, etc. These conditions would apply to all airlines seeking financial assistance. In addition, the Liberals with an eye towards a Spring election (or sooner) would likely impose additional requirements such as reinstating regional air service, possibly re-hiring some or all laid-off staff and using the government’s wage subsidy, and specific to Air Canada, reversing the Airline’s decision to cancel firm orders of the Airbus A220, manufactured in Quebec. Air Canada is the only Canadian buyer of this aircraft.
In her new role as finance minister, Chrystia Freeland reportedly met with both Air Canada and Westjet CEOs and learned that equity participation is a non-starter for the two airlines. At the time, Michael Sabia acting as an advisor to the Liberals was likely telling Trudeau and Freeland the same thing. Sabia, former head of Caisse de Depot, the Quebec Pension fund, and now deputy minister of finance, would understand that the two airlines would not be in favour of government equity participation, and that both companies could just as easily access the financial markets for additional financing. It’s possible Sabia convinced Trudeau to move off the equity participation position, but the Prime Minister still demanded most, or perhaps all, of the original conditions would still need to be met before any kind of lending arrangement (low or zero interest) is offered.
Assuming the vaccine roll-out stays on track, Trudeau will likely call an election in the coming months, in an attempt to win back a majority government. It would be a big win for the Liberals if they are seen among voters as being successful in playing hardball with the airlines, particularly Air Canada and Westjet; but any hope of that ended on Monday when Air Canada announced the equity issue, a move that considerably weakened the federal government’s bargaining position.
Some form of an arrangement may still be reached with the Feds, but all the Liberals can hope for now are ticket refunds and restoration of regional air service subsidized by the government, in return for low interest loans.
So what are the strategic imperatives that may have prompted this offering? Completing the Air Transat Purchase In my November 15 post, Deal of the Century, I suggested that Air Canada may have been one of the purchasers of Air Canada shares on November 9
th, the same day Q3 earnings were released. That day, over 27 million shares were traded. We’ve since learned that Fidelity was a major buyer – over 12 million shares – and shorts were not covering. If Air Canada did purchase shares that day, say 9 or 10 million, then part of this $815 million would be intended for this purchase, approximately $180 to $200 million. As long as Air Canada doesn’t cancel these shares, no requirement exists to report the purchase. These shares will sit in the Company’s Treasury until distributed to Air Transat shareholders who opted for the conversion.
On Monday, the day the voting results were announced, Jean-Marc Eustache, President and CEO of Air Transat commented that if shareholders turned down the deal, management would need to borrow $750 million in 2021 to keep the airline afloat. The messaging was too convenient, given the disclosure of another bidder with a higher cash amount and Air Canada’s offering later in the day. As a standalone entity, Capital IQ consensus cash flow for Air Transat in 2021 (calendar year) is a positive $115 million, and free cash flow is $(150) million.
Before proceeding let’s assume Air Canada’s $850 million equity issue
is solely intended for Air Transat. In its full year earnings pre-Covid19, Air Transat’s revenue was $2,937 million. Its peak revenue occurred in 2014 at $3,752 million. As Air Canada began growing its leisure carrier (Rouge) in 2013, Air Transat’s annual revenues declined.
OTB’s recent post, Air Travel Pricing, provides an excellent summary of Air Transat’s revenue woes (see link below). Under Air Canada’s umbrella, Air Transat will not only be advantaged by sophisticated revenue management software, but also by other IT applications (advanced planning tools, crewing optimizers, etc.) across its commercial and operating branches. These productivity enhancement tools typically don’t fall within the domain of smaller, low-cost and ultra-low cost carriers because of their higher purchase costs.
Gamechangers. Long haul narrow body will reshape networks in the 2020s. There have been several revolutions which shifted the balance of aviation. In order to achieve competitive long haul unit seat economics, it has been necessary to apply the benefits of very large aircraft, more recently as engine technology improved, using twin-engined jets which consumed less fuel. Because of their size, these aircraft were mostly suitable only to service large hubs, but there is a limit to the number of these until-now nascent large volume airports. Now, the new technology that is about to transform medium to long haul travel comes in a much smaller size: single aisle aircraft which have an even better seat economics profile. The result is to allow frequent connectivity between much smaller cities. The longest range of this new breed is claimed by Airbus’ new A321 LR. These very long-haul narrow-body aircraft will revolutionize network planning over the coming decade. They will open up new smaller cities to regular services that were previously deemed unthinkable stimulating widespread new routes networks. The new narrow-bodies usher in a true generational change. (Aviation Journal excerpts)
Air Transat’s fleet in 2014 comprised 25 narrow-body and wide-body aircraft, and 10 seasonal winter narrow-body rentals. Total seating capacity was approx. 8900 seats, of which 20 percent were seasonal. Average annual seat count in 2014 was about 8000 seats. Air Transat’s fleet under Air Canada will comprise 35 narrow-body and wide-body aircraft, all long range, capable of European operations, and with a total seat count of approx. 9900, about 24 percent more than 2014’s average full-year seat count. Average stage length would also increase over this period in view of all aircraft capable of longer flights. Air Canada’s average stage length increased 20 percent over this same period. If we apply a conservative 15 percent increase in Air Transat’s 2014 average stage length, actual capacity measured in available seat miles would increase by upwards of 40 percent in 2023.
With Air Canada retiring its 25 Rouge Boeing 767 wide-body aircraft from the passenger carrying role, the replacement of these aircraft with Air Transat’s Airbus A330s in a high-density seating configuration, and the introduction of the Airbus A321 Long Range aircraft on North Atlantic routes – mostly into secondary EU airports – Air Transat should easily meet or exceed its 2014 revenue stream by 2023. Reduced competition, significant increase in available seat mile capacity, dynamic pricing leading to higher average fares (yield), higher aircraft utilization rates, more favourable fuel pricing, the introduction of Airbus A321 operating economics and other cost cutting and productivity improvement measures in 2021 make this an easy revenue target to reach, along with significant margin expansion.
Here are four valuation scenarios for 2023 with revenue set at $3,750 million:
- 10 percent EBITDA margin and a 5 times EBITDA multiple: $1,875 million
- 10 percent EBITDA margin and a 6 times EBITDA multiple: $2,250 million
- 15 percent EBITDA margin and a 5 times EBITDA multiple: $2,815 million
- 15 percent EBITDA margin and a 6 times EBITDA multiple: $3,375 million
Using the most conservative estimate, last Monday’s additional equity investment should more than double in two years, from $850 million to $1,875 million. A more realistic EBITDA margin for 2023 would be in the 15-20 percent range. You can play with the EBITDA multiples to come up with what you think the value might be. For a 2025 valuation, five or six percent compounded annually is a reasonable revenue growth rate.
You should now have a better understanding as to why the analyst I referred to in my November 15
th post called the Air Transat purchase the ‘Deal of the Century.’
Seizing a Cargo Opportunity Until Covid-19, Air Canada earned cargo revenue by carrying cargo in the belly hold of passenger aircraft. Fifteen years ago, the Airline did have options on two Boeing B777 freighters, but converted these into passenger aircraft. The B777 passenger aircraft has excellent cargo carrying capacity in its belly, and this made the business case for dedicated (and expensive) freighters nonviable.
The air cargo market has since evolved with the growth in e-commerce traffic. Although E-commerce was expanding before Covid-19, Canadians have been slow to embrace digital shopping. In 2019, e-commerce spending in Canada increased by 32 per cent to $2.6 billion, yet that still accounted for less than five per cent of total retail sales, lagging both China and the United States. Since Covid-19, domestic E-commerce traffic has jumped considerably.
“We do not see anything about the current environment that is likely to impact Cargojet’s enviable competitive positioning, virtual monopoly of the overnight air cargo market, and exposure to secular e-commerce trends that will continue to support growth in the years ahead. We have a lot of catching up to do.” (Cargojet Executive quote earlier this year)
On December 16, Air Canada announced that it had completed 4000 all-cargo only flights since March 2020. These flights were completed on both mainline wide-body aircraft and seven transformed wide-body aircraft enabling cargo transport in the cabin.
The Company recently appointed a Vice President Cargo, and reached an agreement with its pilots on reduced pay rates for Boeing 767 freighters. The Company is currently converting four owned B767 aircraft, formerly operated under the Rouge brand, into freighters. Seven of the 30-B767s recently retired are owned. The cost to convert a B767 into a freighter is approximately $15 million USD. Converting six aircraft, rumoured to be the end-state number, would cost about $150 million Canadian.
Here are the Cargojet (CJT) financials:
(Estimates are S&P Capital IQ consensus)
2019 Revenue $487 million
2020 Revenue (estimated) $658 million
Revenue compound growth rate (2005 to 2019) 11.0 percent
Revenue growth ttm (Sep 30, 2020) 29.5 percent
Revenue compound growth rate (est, 2021 to 2024) 7.0 percent
EBITDA margin 2020 estimated 44.0 percent
EBITDA margin 2021-2023 estimated 41.0 percent
CJT’s market cap has grown from $67 million in 2005 to $3,275 million today. Its EBITDA multiple varied in the 4 to 5 times range early on; however, since 2016, its multiple has averaged 13.5 times, varying between 12 times and 15 times. CJT currently trades at an 18.75 EV/EBITDA multiple.
The irony here is that Air Canada generates more cargo revenue annually than Cargojet and enjoys higher operating margins (more than 50 percent) as cargo is only carried in the belly of passenger aircraft. Yet, the market applies the airline multiple (5 to 6 times) to these earnings, while Cargojet is valued using more than twice the EBITDA multiple.
The expected future growth in CJT’s cargo revenue (7 percent based on Capital IQ consensus) is likely too conservative given that Canada lags other major markets in E-commerce development. A more realistic growth rate is probably closer to 10 percent for the Canadian market. It’s possible that analysts have adjusted CJT’s revenue projections lower in view of Air Canada’s recent announcement to convert some of its Boeing aircraft into freighters.
CJT operates a fleet of twenty-four Boeing aircraft – sixteen B767s and eight B757s – with a total payload capacity of 2,600,000 lbs. Air Canada’s six Boeing 767 freighters payload capacity will be about 760,000 lbs, or 30 percent of CJT’s total capacity.
CJT’s estimated 2023 revenue is $780 million based on a 7 percent growth rate. A 10 percent rate would put CJT’s 2023 revenue at $875 million. Assuming all six Air Canada’s B767s are converted and operating at full capacity in 2023, cargo revenue generated should be approx. $260 million, 30 percent of $875 million. The market should absorb this additional capacity given the projected growth in E-commerce traffic as Canada catches up to other countries, so no yield erosion is assumed from increased competition.
Applying a 40 percent margin, EBITDA will be about $104 million. Using a 6 times EBITDA multiple, the estimated market cap would be about $625 million. If CJT’s four-year average multiple of 13.5 times is used, the market cap would be $1,400 million.
Air Canada’s 2020 cargo revenues should finish 20 percent higher than last year’s actuals, or about $850 million. Factoring out cargo revenue associated with Covid-19 and projecting out to 2025, estimated cargo revenue generated on passenger aircraft should be about $1,120. Cargo revenue from Boeing 767 freighter operations should generate an additional $315 million. Total cargo revenue would be about $1,435 million, or more given the synergies that are likely to result from this venture. Given that the majority of Air Canada’s cargo revenue earned will still be carried on passenger aircraft, a reasonable EBITDA margin should be (at least) 50 percent. Air Canada Cargo (ACC) would generate a market cap of $4,300 million using the 6 times multiple assigned to airlines. As a standalone unit, ACC should be awarded a multiple similar to Cargojet, and yield a market cap of $9.7 billion ($717 million EBITDA x 13.5).
From my previous post, 2025 revenue was estimated to be about $23 billion. Air Canada Cargo revenue will represent just over 6 percent of total airline revenue but its EBITDA contribution, along with Aeroplan II’s contribution, will generate well over 50 percent of the airline’s total EBITDA. Cargo’s almost recession proof business model along with its higher operating margins will be one more piece in the justification for a higher earnings’ multiple. Additionally, the cargo business is somewhat counter cyclical to the airline passenger business with higher traffic and yields in the winter period.
Air Transat + Air Canada Cargo Imperative
So far, a total of $350 million of the $815 million equity issue has been spent, $200 million to the Air Transat shareholders and $150 million to the cargo imperative. A combined 2023 conservative market cap from these investments is about $2,900 million, using a 6 times EBITDA multiple.
$2,250 million (Air Transat) + $625 million (Boeing 767 Freighter Operation)
This leaves about $460 million of the equity issue to make other another opportunistic acquisition(s).
The Third Imperative – The Purchase of Jazz?
My October 29 post, Thoughts on the Non-Binding Acquisition (see link below), alluded to the possibility that Air Canada may acquire the regional airline component (called Jazz) of Chorus Aviation. I mentioned that Air Canada acquired just under ten percent of Chorus in early 2019, and with shares trading significantly below their 12-month highs, this would be an opportunistic purchase.
Jazz was monetized and sold off during CCAA. The purchase of Jazz would remove the inflexibilities associated with the third-party arrangement (flight hour guarantees, etc.) and the fixed-fee compensation structure. The net result would increase Air Canada’s future free cash flow.
Following the 2008 financial crisis, the NA regionals went through a restructuring period, resulting in bankruptcies, mergers, privatizations, or acquisition by a major airline. For example, following Chapter 11, Pinnacle was acquired by Delta in 2009. Regional airline operating margins have declined from the mid-teens before the recession to mid-single digits today, typically 6 percent. Regional airlines are also moving away from operating smaller aircraft, and because they’re paid by the block hour, larger aircraft mean fewer trips, fewer block hours and less revenue.
It is likely that 6 percent is the current fixed-fee compensation structure that Air Canada negotiated with Chorus in 2015, when an agreement was reached to move off the ‘cost-plus’ mark-up of 12.5 percent. This change resulted in approximately $550 million in ‘financial value’ given back to Air Canada over a five-year period, or about $110 million annually. The term ’financial value’ was never defined, but a reasonable assumption is that a buy-out would remove the fixed-fee rate of 6 percent, and yield a similar ‘financial value’ of $110 million annually.
And Chorus would not likely be opposed to selling off its airline operation. The regional model using the capacity purchase agreement in not only inflexible for the mainline carrier, but the regional airline has little control over the business, and little leverage when it comes to negotiations. Some portion of the costs will be reimbursable at pre-determined rates, but if costs rise higher than those rates, then Chorus will have to absorb the balance until it can negotiate a better deal with the next contract.
The Covid-19 crisis presents an opportunity for Air Canada to re-acquire Jazz for much less than what it was sold for in 2004 and much less than what it would pay for the airline had the crisis not occurred. With Air Canada already owning 10 percent of Chorus, it’s entirely possible that the acquisition of Jazz could be completed and paid for with remaining funds from the offering.
The Dilution Effect and Future Buybacks – Short Term Pain, Long Term Gain
With Monday’s announcement of a share offering, Air Canada’s float will increase by about 35 million shares. Added to the current float of approx. 297 million shares, total shares outstanding will now stand at about 332 million.
In previous sections, we see that funds from the offering suitably invested will lead to higher free cash flow generation in future years, and it’s this additional free cash flow that will be used to re-purchase shares.
Share buybacks will begin no later than 2024. Below are two EBITDA estimates for 2024 and 2025. Keeping in mind that revenue projections for these years are conservative, the free cash flow generated each year(in bold) should be as follows:
(Canadian dollars, in billions)
Year Rev EBITDA % EBITDA CFO Capex FCF
2024 22.0 25 5.51 5.95 0.73 5.22
2025 23.1 25 5.79 6.25 1.00 5.25
Total 10.47
Year Rev EBITDA % EBITDA CFO Capex FCF
2024 22.0 23 5.06 5.46 0.73 4.73
2025 23.1 23 5.31 5.73 1.00 4.73
Total 9.46
After interest payments in these two years, and assuming a dividend is not paid, remaining free cash flow would still be in the $9 billion or $10 billion range, depending on which EBITDA margin is achieved, enabling a significant share re-purchase program.
If we take the conservative $9 billion and assume a $100 average share price over the two-year period, then up to 90 million shares could be re-purchased, leaving approximately 240 to 250 million shares outstanding by end-2025. Given net debt of $3 billion and a 6 times EBITDA multiple, the estimated share price would be in the $115 range.
In all likelihood, the three strategic imperatives discussed above should lead to the 25 percent EBITDA margin target and the higher free cash flow generation that comes with that.
Additionally, the acknowledgement by the market of Air Canada Cargo as a higher margin business, countercyclical in nature and independent of airline economics, along with Aeroplan II, a lucrative loyalty program with similar earnings dynamics, could lead to overall higher valuation multiples.
If you’re an investor, you’re looking on what the asset is going to do; if you’re a speculator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game.
– Warren Buffet, Outstanding Investor Digest