Making Cents of Air Canada's Fleet Roger Sterling, “They’re daring them to bomb us, right when I got a second chance.”
Don Draper, “We don’t know what’s really going on,” Don says to Roger. “You know that.”
Scene from an anxiety and paranoid laden Madmen episode when the Cuban Missile Crisis is threatening to annihilate everyone.
The Strange Rites story at the beginning of my last post (see link) is an important one that has a lesson we can all learn from.
Is Opportunity Knocking?
It’s easy for us to recognize the ‘out-of-context’ viewpoint the observer in the football game experienced when others are commenting on a subject falling within our own area of expertise. A highly respected Bay Street Wealth Management CEO appearing on a BNN call-in show in 2019 advised a caller to consider selling Air Canada shares. Why? Well, because WestJet had just bought Air Transat and the merged carrier was going to become a formidable competitor to Air Canada in its own backyard. The same wealth manager then began to toot Delta Airlines. His firm bought shares in Delta, but only after Buffet’s 2016 purchase of Delta and three other U.S. carriers (just out of shear curiosity I checked his firm’s purchase date after the show). By 2018, any investor with a reasonable knowledge of the airline industry, knew Delta’s share price had run out of lift and was not going any higher, any time soon.
We also see out-of-context viewpoints by the media following company earnings’ calls.
Thinkyourmoney made similar points in a recent post.
Observations on Q3 Earnings
https://stockhouse.com/companies/bullboard/t.ac/air-canada-inc?postid=34079336 So, what’s the message? We should avoid being smug about the CEO’s sin. We do it too, more often than we think. Sometimes, the best response on a subject beyond our field of expertise is something along the lines of Draper’s response to Roger in the Mad Men episode. When it comes to investing, we’ve all committed this error. Going outside our area of expertise, overconfidence, believing we know more than we do, will often get us into trouble. I think the writer’s intent in the Strange Rites story is to show us when we are wandering outside our lane. We’ll re-visit ‘smugness and sins’ later in the post. From Q3 MD&A and the earnings’ call, five more Boeing B737 Max 8 aircraft and three Airbus A-220s, all narrow-bodies, will be delivered in Q4, and will be paid for in cash, in other words no additional debt financing or leasing obligations.
Next year, the remaining nine Boeing 737 Max 8 deliveries will be completed by June in time for the busy summer flying schedule. This is good news as these aircraft form the backbone of Air Canada’s sixth freedom higher margin traffic to/from the United States to Asia and Europe with shorter in-transit times. Six Airbus A220s will also be delivered in 2022. Financing for these aircraft was arranged through a secured facility earlier this year. As these new fuel-efficient aircraft arrive in Q4 this year and throughout next year, older Airbus A319s and A320s are being removed from fleet, many of them leased.
Air Canada also exercised options for three stretched B787-9s to be delivered in 2022 and 2023. Many investors assume these are growth airplanes, and they may very well be. But there are other possibilities. The B787-9 entering the fleet next year could be a replacement for one Boeing 777-300 aircraft exiting the fleet in Q4, likely a lease return. The remaining two B787s arriving in either 2022 and/or 2023 could also replace the smaller B777-200 LR (long range) aircraft. There are six in the sub-fleet, two of them leased. This jet has the same seating capacity as the B787-9 but has13 percent greater range. If a longer range is not needed, then the more attractive operating costs of the 787-9s make the smaller B777 a logical replacement.
While these B787s could form part of the settlement with Boeing (Max 8 grounding), another possibility is an opportunistic purchase. Boeing currently has a delivery freeze on B787s, and leasing companies and airlines are complaining 787 deliveries are delayed up to 12 months. One leasing company recently cancelled orders for three Boeing 787s it expected to deliver to one of its customer airlines later this year. These could be the same aircraft Air Canada purchased.
Knowing Air Canada’s cash rich position, Boeing likely approached the Airline with an attractive offer. In 2016, Air Canada completed a sale and lease back transaction on two B787s delivered that year. Accounting for gain on sale of aircraft to lessor at fair market value, the price in USD for the aircraft was $128 million. Given higher margins on stretched wide-body aircraft, it’s likely under the circumstances the three were acquired at a substantial discount. Boeing reportedly earns an average profit of more than USD $35 million on a Dreamliner.
In previous posts, I suggested Air Canada’s focus is on growing ROIC above 20 percent while creating a resilient, competitive moat, to sustain these returns. An opportunistic purchase of three B787s fits with these goals.
One attribute in creating a competitive moat is cost advantage, and aircraft acquisition cost is a significant component in the cost per seat mile calculation. Although it can’t be known for certain what WestJet paid for its B787-9 fleet, some background might be useful in showing Air Canada paid significantly less for its fleet of B787-9s, and other fleet acquisitions too.
In 2005, Air Canada signed an agreement with Boeing for the purchase of up to 36-Boeing 777s and 60-B787 jets, with firm orders for 18-B777s and 14-B787s. The firm order was valued at $6 billion at list prices. Boeing’s pricing strategy was intended to persuade Air Canada to switch its wide-body fleet from Airbus to Boeing. Air Canada was one of the first major non-US purchasers of B787 aircraft, with the 35
th aircraft in the production line destined for the Airline.
The 787
Dreamliner was still in the design stages in 2005, and Boeing in its effort to stimulate global sales, priced the first version of the aircraft – the Dash 8 – close to the earlier (and smaller) B767-300 ER model, at a reported list price of USD $120 million. In 2020, Boeing lists the same B787-8 at USD $248 million, more than double its initial price in 2005. Discounts from list prices vary and depend on a few factors but can be up to 50 percent or more. Given Air Canada’s order size, year of purchase and Boeing’s pricing strategy, it’s a reasonable assumption Air Canada’s acquisition cost of the 787 was among the lowest in the industry, if not
the lowest.
Originally scheduled for delivery in early 2010, the 787 encountered flight test and production delays pushing delivery dates into 2011/2012. Boeing compensated airlines for the delay, effectively reducing average price paid per fin. Production delays continued pushing deliveries into 2014. Boeing may have provided additional discounts as further delays were encountered, although this cannot be verified. Of the 37 aircraft eventually delivered to Air Canada, only six are leased.
Elaine: “I hate smugness. Don’t you hate smugness?”
Cabdriver: “Smugness is not a good quality.”
Scene from Seinfeld
WestJet, on the other hand, ordered twenty B787-9s in May 2017, ten firm orders and options for ten more, a small order compared to Air Canada’s. When the first three aircraft were delivered, WestJet announced sale and leaseback agreements for all three. The latest information available is at least six B787s are now in WestJet’s fleet and a reasonable assumption is that because of the Covid-19 crisis, these and subsequent deliveries may also be sale and leaseback transactions.
In view of price escalation between 2005 and 2017, WestJet’s ‘entry fee’ into the international market was much higher, a risky venture considering the fuel component on longer range flying consumes a much greater component of the overall seat cost per mile, a factor wiping out much of the cost advantage that low-cost carriers enjoy domestically.
Staying in your lane…
Chris Murray, an analyst with AltaCorp Capital Inc., said he is cautious on the introduction of (WestJet’s) wide-body fleet, due to capacity management and cost concerns. “We still struggle to see the economic rationale of the wide-body strategy in any form that brings them into a different part of the space where perhaps they don’t have a more competitive offering,” he said. “Part of the challenge is getting a lot of return to justify the capital.” Financial Post, May 2017
Given WestJet’s late entry into the long-haul market, its purchase of B787s twelve years (of price escalation) after Air Canada’s purchase, not being a launch customer, a smaller fleet purchase discount, not benefiting from additional discounts/financial compensation for delivery delays, and a higher percentage of operating leases one can reasonably conclude Air Canada has a definite structural fleet cost advantage over WestJet in the long-haul market.
Erosion of WestJet’s Cost Advantage: What happened and why?
WestJet’s strategic blind spot concerning fleet strategy was its failure to recognize an industry shift to an up-gauging strategy following 2008’s oil crisis and increasing pressure from institutional investors wanting airlines to place greater emphasis on capital returns.
Maximizing ROIC is about putting the right airplane on the right route, at the right time.
Next, WestJet executives, feeling smug about their early successes, and armed with a ‘competing to be the best’ mindset, were drawn into what Michael Porter calls competitive convergence, the ‘grandaddy of mistakes’, the slippery slope in the race to the bottom, competing on price alone. Their executives also committed Porter’s second worst error in strategy – competing with rivals on the same dimension. Execution has been poor.
As WestJet moved away from its original business model – Southwest’s model – in pursuit of growth, executives continued to adhere to the ‘one aircraft type fits all’ mindset that Southwest is famous for, when a more appropriate fleet strategy for the new business model was to acquire ‘game-changer’ aircraft as they became available, even if it was from another manufacturer. Rigidly adhering to a one-fleet strategy, WestJet tied itself to Boeing’s failures, in this case, the marketing failure of its B737 Max 9. Opting for the Max 10 instead, WestJet’s delayed entry into the 180+ seating category market will not occur before 2023, at the earliest, and won’t be completed until 2025-2027.
What was WestJet executives’ biggest sin? They assumed away the capabilities of their main competitor, Air Canada. When Onex entered the arena, in early 2019, WestJet’s ROIC had fallen to five percent, well below its cost of capital.
In the narrow body market Air Canada also holds a fleet cost advantage over WestJet for similar reasons: lower aircraft acquisition costs, fewer leases and a younger narrow body fleet with fuel-efficient aircraft and lower operating costs. Boeing’s pricing strategy for the B737 Max 8 persuaded Air Canada to switch from its Airbus fleet to a Boeing fleet. WestJet, already with a narrow body Boeing fleet, did not have this leverage, and its initial order for the Max was smaller than Air Canada’s by one-half.
But it is the game-changing Airbus A220-300 (originally a Bombardier product known as the C-Series) that gives Air Canada a huge cost advantage against WestJet in the 130-140 seat category. The A220-300 was designed to compete head-to-head with the Boeing 737-700 and Airbus 319 series aircraft. Sales of these smaller variants evaporated overnight after oil peaked well above USD $100 in 2008. Bombardier targeted this market with a much lower cost, more fuel-efficient jet with similar range capabilities as the Airbus 319 and Boeing 737-700 NG, an older model WestJet operates (the Max 7 version has a 15 percent greater range capability).
Both Boeing and Airbus variants are smaller derivatives of the original airframe. A problem with smaller derivatives is that they’re tied to the higher cost original airframes, the Boeing 737-800 and Airbus A320s. Only two airlines globally ordered the smaller Boeing 737 Max 7s: Southwest and WestJet. Southwest is an all Boeing 737 operator (700 and 800 series), and the smaller size makes sense on certain routes flown by the airline. But WestJet’s decision to purchase Max 7s doesn’t make any cents going forward considering the industry’s move away from the smaller variants, and its main competitor’s decision to acquire a fleet of Airbus A220-300s.
Reporter: General, given your presentation tonight about the effectiveness of the coalition Air Forces, is there a chance that there won't need to be a ground war?
General (Norman) Schwarzkopf: Oh, there’s always a chance of that, but certainly you know as military planners, you always plan for the worse case rather than the best, and I’m not going to assume away the capabilities of the enemy at all.
Press Briefing on Gulf War progress
On routes WestJet is operating older B737-700 NGs, and its yet to be delivered fleet of Max 7s, Air Canada will have a significant cost advantage with its Airbus A220-300. While WestJet will be operating a more expensive airplane, carrying up to 130 passengers, Air Canada will be operating a much less expensive aircraft carrying up to 137 passengers. Recall earlier in this post that Air Canada was the launch customer for the 300 series and acquired these aircraft at a significant discount, reportedly under $50 million Canadian per fin.
At present, a huge hole exists in WestJet’s narrow body fleet in the 180-220 seat category. The airline doesn’t have capacity in this seat range. Air Canada operates 29-Airbus A321s under both Mainline and Rouge brands. Mainline has 15 aircraft with seat capacity of 190 while Rouge operates 14 aircraft with seat capacity between 200 and 220 seats. Simply stated, WestJet cannot effectively compete against Air Canada in this category. As mentioned earlier, WestJet ordered 12-Boeing 737 Max 10s, but deliveries only begin in 2023. The Max 10 is intended to compete with the Airbus 321 LR. According to WestJet’s last public document, WestJet will take delivery of 36 Boeing narrow and wide body aircraft, mostly replacements, some growth, about a quarter of its total fleet, in the next three years.
Making Cents of it All
Much care has evidently gone into the planning of WestJet’s methodically designed fleet.
– an out-of-context perspective
The denominator for ROIC is invested capital. Air Canada’s advantage over WestJet is that for every dollar of invested capital WestJet spent on new aircraft, and importantly the right new aircraft, Air Canada spent less. Actual discounts cannot be known, but given the background information provided in this post, a conservative assumption would be in the 75 to 80 cent range – perhaps lower when B787 Dreamliners and Airbus A220s are factored in – for every dollar WestJet spent.
Stated differently, for every dollar spent on fleet renewal/growth, Air Canada acquired more assets than WestJet, enabling the former to generate greater cash flows per dollar of invested capital well into the future.
Air Canada’s acquisition of both wide and narrow body aircraft – major fleet purchases, opportunistic purchases, lower reliance on new aircraft leases and acquiring the right aircraft for a particular role – at favourable prices provides a long-term structural fleet cost advantage over WestJet. With the capital cycle almost complete, the foundation for sustainably higher ROICs has been established.
The essence: Don’t confuse the container with its content.
The core of an airline’s capital base is its fleet, and the core of an airline’s value chain is its capital base. The secret to a sustainable competitive advantage lies within the design of the value chain.
In making cents of each airline’s capital base, an insightful investor will see a design in one capital base, and an absence of design in the other.
Diversification is a confession that you don’t really understand the businesses you own.
– Charlie Munger