An Update on Air Canada FinancesSummer Capacity Guidance In my most recent post (see link below), I made the case that Air Canada put more capacity into Q3 than its forward guidance indicates. Specifically, I believe the capacity is likely in the 60 percent range of 2019 Q3 capacity, rather than the approximately 35 percent they set forth in forward guidance. (Keep-in-mind that this passenger capacity measure doesn’t include cargo capacity, with eleven wide-body aircraft operating in a cargo configuration, about 30 percent of its B777 fleet and 25 percent of its A330 fleet.) At the time this guidance was issued in July, the Airline was well into its Q3 operation, and executives would have a pretty good idea of how the summer is going to turn out. So why the gloomy guidance? I’ll revisit this question later.
Q3 Cash Burn Guidance In its Q2 cash burn guidance for Q3, Air Canada projected a net cash burn between $280-$460 million for the quarter. Assuming the capacity guidance is based on the advertised 35 percent capacity level flown in 2019 cash burn for Q3 should therefore be
much lower given the Airline has put an estimated 60 percent capacity into the summer quarter.
Financing Strategy
Last fall, I predicted that Air Canada’s weighted average interest rate on its long-term debt would fall below 4 percent exiting Covid-19. At the time (Q3 2020), the weighted average was 4.41 percent. At the end of Q2 2021, the average rate dropped to 3.93 percent, or an after-tax cost of 2.87 percent. This is highly efficient debt.
Let’s drill down to get a closer look at the Airline’s most recent financial arrangements to better understand what may be transpiring on the financial front, and possibly on the overall corporate strategy.
Large Employer Emergency Financing Facility (LEEFF)
Recall on April 12, Air Canada entered a debt and equity financing arrangement with the federal government allowing the Airline to access up to $5.879 billion in liquidity through the LEEFF program. The agreement included the following:
- an equity infusion of $500 million (net proceeds $480 million) for 21,570,942 shares at $23.18/share
- $1.5 billion secured revolving credit facility, against certain Air Canada assets, maturing in April 2026 and bearing interest at the Canadian Dollar Offered Rate (CDOR) plus 1.5 percent
- $2.475 billion in the form of three unsecured non-revolving credit facilities of $825 million each: a five-year tranche maturing in 2026, at CDOR plus 1.75 percent/annum; a six-year tranche maturing in 2027, at 6.5 percent/annum (increasing to 7.5 percent after 5 years); and a seven-year tranche maturing in April 2028, at 8.5 percent/annum (increasing to 9.5 percent after 5 years)
- As consideration for the Government making the above secured and unsecured credit facilities available to Air Canada, the Airline issued 14,576,564 warrants at an exercise price of $27.2698 per share, 50 percent of the warrants vested concurrently with the implementation of the credit facilities and the remaining 50 percent of the warrants will vest on a proportional basis to the amounts that Air Canada draws under the above unsecured credit facilities, with a one-time call right in favour of Air Canada, upon repayment of all indebtedness, for repurchase and cancellation of all outstanding warrants at a price per warrant equal to its fair market value determined by third-party valuators
- Up to a $1.404 billion unsecured credit facility to support customer refunds of non-refundable tickets, with a seven-year term at an annual interest rate of 1.211 percent
The $480 million in equity was used to repay the US$400 million unsecured note @7.75 percent interest due earlier this year. To date though, the Company has
only used the $1.404 credit facility to refund the non-refundable tickets. According to Q2 MD&A, as of June 30, 2021, $997 million has been drawn under the facility for refunds paid up until June 30, 2021. It is expected that an additional $200 million will be drawn down in Q3. Drawdowns from this facility expire on November 30, 2021.
As a result of the LEEFF program, at the end of Q2, unrestricted liquidity stood at $9.77 billion, including cash, cash equivalents and short and long-term investments $5.66 billion. Net Debt is $7.085 billion.
The underlined text highlights some key points and possible outcomes. First, the $1.404 billion unsecured credit facility is not linked to the warrants. Second, in view of the most recent financial arrangement discussed below, it appears that Air Canada intends to extricate itself from the LEEFF program. It is not entirely clear what the term ‘implementation’ means: do the first 50 percent of warrants vest on the signing of the LEEFF agreement, or do they vest only when the Company begins to withdraw funds from the revolving/non-revolving credit facilities? Assuming the former is the case and in view of the current share price, it would make sense for Air Canada to have a third-party place a value on the 7,288,282 vested warrants, repurchase them from the federal government, and cancel the warrants. Perhaps this is the reason for the gloomy Q3 guidance. A more negative outlook would help make the case for a lower warrant value.
The equity infusion and attractive loan terms on the $1.404 billion unsecured credit facility could be one reason that the Company entered this arrangement with the government: To take advantage of certain aspects of the LEEFF program while putting a more comprehensive and attractive financial arrangement in place. Air Canada gets to exit the program with a $500 million equity infusion and a seven-year, 1.211 percent loan up to $1.4 billion.
If Air Canada were looking to acquire a small fleet of Airbus A321neo LR aircraft (new or almost new), which may still be available at significant discounts, an acquisition of this kind, packaged with the favourable terms (equity plus 7-year loan at 1.211 percent) provided under the LEEFF program, would enjoy higher margins offsetting the effects of share dilution. Of course, these aircraft may also be acquired at more attractive lease rates now than was the case pre-covid. Pre-covid, leasing companies had secured early deliveries, and a new order from Airbus meant delivery no sooner than 2024. During the covid crisis, many of these (new and almost new) aircraft became available as airlines downsized and/or restructured.
Last year, Air Canada cancelled orders for 11-Boeing B737 Max 9 aircraft. The Max 9 variant is the stretched version of the Max 8, but the aircraft failed to meet performance specs, particularly in the range category. The Airbus equivalent is the Long Range (LR), an aircraft with much greater range capability than the Max 9, similar operating seat costs as the Boeing B787 and ideally suited to operate on the North Atlantic into smaller European airports. Air Transat plans to operate a fleet of 15 (or more) of these aircraft, but when Air Canada walked away from the merger, it left a ‘hole’ in its fleet plan. The Airline currently operates 29 earlier models of the Airbus A321, fifteen in Mainline and fourteen in Rouge.
Although the seven-year term loan is being used to make payments to customers on non-refundable tickets, the Company at the same time is experiencing an increase in advanced ticket sales, offsetting the cash outflow. On the Q2 earnings call, the CEO said the company saw a significant increase in bookings once travel restrictions were lifted in June.
Upcoming Capital Expenditures and Financing Requirements In November 2020, Air Canada amended its agreement with Boeing to cancel 10-Boeing 737 Max 8 firm orders from 50 to 40 aircraft and to defer its remaining 16 aircraft deliveries over the late 2021 to 2023 period. The latest MD&A shows 27 Max aircraft in the fleet at year-end 2021, meaning thirteen will be delivered in 2022 and 2023.
In previous posts I mentioned the Boeing settlement reached last year, resulting from the B-737 Max grounding, is estimated to be more than $1 billion, comprising cash and ‘in-kind considerations, with most of the settlement comprising ‘in-kind’ consideration, planes and parts. The smaller cash payout portion occurred in 2019. Boeing in its attempt to limit cash outflow and spread the ‘compensation’ for damages into future years would have offered higher discounts for future aircraft deliveries and even higher discounts on aircraft parts, components typically having much higher profit margins than aircraft margins. (Airlines usually negotiate a parts package with the purchase of aircraft to avoid paying higher prices later.)
For their part, Air Canada would be looking to minimize income tax paid, if any, on the settlement while taking advantage of the Canadian Revenue Agency’s accelerated capital cost allowance (CCA) introduced by the federal government a few years back to encourage capital expenditures. The accelerated CCA will serve to increase cash flow with the delivery of the remaining Airbus and Boeing narrow-body fleet. All said and done, these ‘in-kind’ considerations (and accelerated write-offs) should cover most of the acquisition cost of the remaining 16 aircraft yet to be delivered. In other words, financing should not be required for the remaining Max aircraft.
In March 2021, Air Canada concluded a committed secured facility totaling US$475 million to finance the purchase of 15-Airbus A220 aircraft scheduled for delivery in 2021 and 2022. By the time the 15
th aircraft is delivered in 2022, total fleet size will be 33. The remaining 12-A220s deliveries slated for delivery in the latter part of 2022 and early 2023, involving a capital expenditure of about $550 million, will also not likely require financing.
For 2022 and 2023, the delivery schedule for the remaining narrow body fleet shows 13-Boeing B737 Max 8 aircraft, and 18-Airbus A220 aircraft. In a post last year, I estimated the acquisition cost for the A220 to be about $46 million CDN. If the remaining Boeing aircraft are to come at little or no cost to the Company, then total capital expenditure for A220 deliveries in 2022 and 2023 would be about $850 million (18 fins x $46 million), yet capex in the latest MD&A is shown as just under $1.5 billion ($1001 million + $495 million, see table below). So, the recorded capital expenditures in the MD&A for these two years may not reflect benefits from the Boeing settlement.
For 2022 and 2023 then, the relatively low capital expenditures will enable the Company to generate much higher amounts of free cash flow, increasing cash levels and reducing net debt, and pushing the leverage ratio into investment grade territory. Both Delta and Westjet Leverage Ratios were in the 1.4 to 1.5 times range when these companies were awarded investment grade ratings on their debt. (Leverage Ratio is not the only criterion).
Following Q2 2021 results, TD Securities updated its estimates for Air Canada, with an estimated leverage ratio of 0.7 times by year-end 2023. TD’s free cash flow estimates for 2022 and 2023 are $2,476 million and $2,968 million respectively. These estimates reflect the current (gloomy) cash-burn guidance for Q3 but not ‘in-kind’ considerations resulting from the Boeing settlement reflecting a lower capex during these two years.
Air Canada’s Principal Obligations In Q1, the Company’s debt repayment schedule was adjusted for the years 2022 to 2024. Long-term debt repayment for 2022 was reduced from $665 million to $488 million. For 2023, debt repayment was reduced from C$2.275 billion to C$1.715 billion. For 2024, debt repayment was increased from C$1.254 billion to C$2.021 billion. This was likely done to align the higher debt repayment with increasing free cash flows over the next three years. These adjustments were completed prior to LEEFF.
Year
2022 2023 2024 2025 Long-term Debt (millions) 488 1,715 2,021 1,710
Committed Capex (millions) 1,001 495 196 ----
At the end of Q2 2020, the current portion (due in next 12 months) of long-term debt is $488 million.
Air Canada Completes Refinancing Transaction Exceeding C$7.1 billion On August 11, the Airline announced the completion of a re-financing transaction of more than $7.1 billion CDN. The agreement included the following:
- C$2.0 billion of 4.625 percent senior secured notes due in 2029
- US$1.2 billion of 3.875 percent senior secured notes due in 2026
- US$2.3 billion term loan B due 2028
- US$600 million revolving credit facility due 2025
All notes, loans and revolving credit facilities are secured against most of the Airline’s international routes, airport slots and gate leaseholds.
The Canadian notes will be used to retire senior, and second lien secured notes totalling $1.040 billion (8.18 percent interest) due in 2023 and 2024. Most of these notes ($840 million @ 9 percent) were offered in June 2020. The other $200 million note (4.75 percent), which formed part of an Oct 2016 financing arrangement, is due in 2023 while the $840 million is due in 2024. The remaining $960 million will be retained for working capital and other corporate purposes.
The US$1.2 billion note will be used to repay US$1.178 billion borrowed in October 2016. Of this total, US$800 million is due in 2023 while US$300 million is due next month.
Interestingly, the press release makes no mention of the purpose for the US$2.3 million term loan due in 2028.
Given the information provided in this latest financial arrangement, it appears that Air Canada is taking advantage of attractive terms now – in anticipation of higher rates in upcoming years – to cover debt repayments between now and end-2023, as well as provide additional working capital in the meantime. (Some of the higher interest rate debt acquired since the crisis began may have early repayment options.)
This debt has more favourable terms than the $C2.475 billion credit facilities offered under the LEEFF program and replaces higher cost debt maturing in 2023 and 2024 so the weighted average rate will remain below four percent for the longer-term. Some of the cash from this re-financing will likely be placed into long-term (more than one year) investments where it will earn higher returns thereby offsetting much of the interest costs until the 2023/2024 notes are repaid.
Principal repayments for most of this re-financing are beyond 2025, beyond the period in which Air Canada’s net debt becomes insignificant, essentially $1 billion, or less.
To Summarize: - in Q1 the medium-term debt repayment schedule was adjusted so that higher debt repayment is aligned with growing free cash flows
- in Q2 up to $1.9 billion was acquired through the LEEFF program, the loan portion having very favourable terms
- end-Q2 liquidity stood at $9.77 billion, including cash, cash equivalents and short and long-term investments totalling $5.66 billion, and average long-term debt cost now under four percent
- Q3 capacity guidance is overly conservative, cash burn guidance is likely much lower
- Q3 $C7.1 billion re-financing is significant, comprehensive and comes with favourable terms
- funding for medium-term principal repayments (2023 and 2024) form part of this arrangement with most of the principal obligations from this financing due beyond 2025
- Boeing ‘in-kind’ consideration portion of the settlement will reduce capital expenditures on the remaining B737 Max 8 deliveries over the next two years and should remove the requirement for financing
- financing for most of the future Airbus A220 deliveries is completed, the remaining fleet deliveries should not require financing given increasing free cash flow generation in 2022 and 2023
- increasing operating cash flows, tax loss recovery, accelerated capital cost allowance, and lease liability reductions (in addition to significant cost reductions achieved during covid) coupled with decreasing capital expenditures will be contributing factors to a growing free cash flow story in 2022 and 2023, pushing the Leverage Ratio into investment grade territory by end-2023
- in view of the above, the more favourable terms and amounts in the Q3 re-financing arrangement suggest that the Company will likely exit the LEEFF program much sooner than expected
- approximately 7.3 million warrants (if issued) could be repurchased from the federal government and cancelled
Given the dollar amount of this re-financing, it appears this latest arrangement at favourable terms obviates any financing for the foreseeable future. It locks in lower rates for the long-term, provides
more than adequate cash levels in the short to medium-term, and could enable the Air Canada to acquire a sub-fleet of Airbus A321neoLR aircraft and/or pursue other opportunities that may fit within its ‘go forward’ strategy.
In a post last fall, I mentioned that the Company may be interested in re-acquiring the airline component (Jazz) of Chorus Aviation. Jazz was sold off as part of restructuring in 2003. Air Canada acquired ten percent of Chorus shares in early 2019. Other airlines, such as Delta, have re-acquired their feeder airline. Doing so would remove the costs and inflexibilities associated with a third-party arrangement and contribute to higher free cash flows in future.
Optimism is a belief that the odds a good outcome are in your favour over time even when setbacks occur along the way.