The Vagaries of Value Creation The Capitalist’s Dilemma
“Clayton Christensen, a professor at Harvard Business School, argues that an undue focus on financial metrics, including return on invested capital (ROIC), has led to underinvestment in growth and innovation. He calls this the “capitalist’s dilemma.” Slavishly beholden to financial metrics that measure value creation, business leaders fail to create value.”
Medium-Term Gain, Longer-Term Pain (for the airlines)
Enhanced Capital Management: fly an older fleet, sweat the assets, generate high ROICs and free cash flows, return cash to shareholders and following stupendous gains, sell the stock and move onto another industry.
From a December 2014 Credit-Suisse Report ROIC is the Barometer of Success: (extracts from the report, underlining and comments in brackets are mine)
“The key drivers of the US airlines’ profit recovery have been capacity discipline, scale expansion, wage/cost controls, and enhanced capital management…significant investments in new aircraft and heavy debt loads have also created upward pressure on invested capital bases, reducing returns…capital-efficient aircraft (older) acquisition should aid in ROIC improvement…increasingly generous capital management programmes (deferring new aircraft deliveries in favour of older aircraft) that see excess free cash flow returned to investors is proving a significant draw-card for the sector that has returned to an "investable" status…in other geographies, the sector-wide trends are less obvious, with the industry showing less collective resolve to generate improved returns than their US peers.”
“United management announced earlier this year (2014) it will pursue opportunities in the used aircraft market, making more return-driven decisions that would result in capital expenditures below its previous plan of US$2.8-3.0 bn from 2014 to 2017.”
“In 2015, American Airlines will take delivery of 76 replacement aircraft, providing a relative unit cost advantage and the youngest fleet ageamong US carriers by several years. But, this comes at a cost as capex is more than twice Delta and United Airlines at US$5.5 bn per year, limiting American Airlines' ability to pay down debt and return cash to shareholders and thereby putting upward pressure on the invested capital base…in both Europe and APAC (Asia Pacific Airlines), re-fleeting has seen capital spending dilute returns as the region has focused on product to the exclusion of ROIC…although…they should also see unit costs decline most rapidly on account of their fleet investment.”
In view of Delta’s 2013 and YTD 2014 financial performance and low capital expenditure rate and under pressure from shareholders, United Airline’s leadership in Q3 2014, announced they were ‘managing down capital expenditures’ by deferring new aircraft deliveries in favour of used aircraft. United leadership’s re-stated financial objectives were for consistent, manageable levels of capital investments (under 7 percent of sales) with the goal of improving earnings, cash flow and ROIC, over assets. With this announcement, Credit-Suisse analysts anointed United Airlines as the next Delta Airlines with an outperform rating and share price target 33 percent higher than its current price.
United’s 2014 decision to defer new aircraft deliveries (at low interest rates) and acquire used aircraft instead meant that by year-end 2020 the airline assumed the oldest fleet position and highest relative unit operating costs. United’s fleet age is now over 16 years. Delta advanced to 14.6 years after retiring older jets last year due to Covid-19. American Airlines and Southwest by comparison have fleets with an average age of 11.2 years and 12.5 years respectively. (Source: Planespotters.net)
Shorter-Term Pain, Longer-Term Gain (for the airline and its shareholders)
Christensen’s point in the ‘capitalist’s dilemma’ quote is that it is the misuse of financial measures such as free cash flow and ROIC that is the problem. Instead of focusing solely on maximizing ROIC and free cash flow, management must take a longer-term view and focus on maximizing economic profits, which necessarily means undergoing the burden of capex not only for competitiveness, in its race for efficiency, but also for long-term value creation. Pathway to Value Creation: McKinsey Report
The race for efficiency: Burdening capex as a prerequisite for competitiveness
Transportation assets are becoming smarter, greener, and larger. Companies need to invest constantly in new-generation assets to remain competitive, while retaining capital discipline. Companies endowed with older assets in capital-intensive industries are typically able to generate windfall profits. However, the opposite holds true for the transportation industry. There is a strong inverse relationship between economic profit and the average age of an airline. Asset size has roughly doubled every ten years, reducing unit costs by 16 percent for new-generation aircraft. Furthermore, scale and technological progress have driven up the operating efficiency of new assets. New-generation assets are 10 to 30 percent more efficient than previous generation assets and have correspondingly lower unit operating costs.
Air Canada’s average age for its mainline fleet will be 6.5 years by year-end 2021, the youngest fleet and best relative unit costs of the major NA carriers. (Source: Investors’ Day Presentation)
Valuation Mismatches In its December 2014 report, Credit-Suisse provided one year price targets based on forecast 2015 ROICs using an in-house linear regression model of EV/IC vs ROIC. This model was intended to identify mismatches using ROIC only (high ROIC and low EV/IC).
In a previous post, Revisiting Air Canada’s 2025 Valuation (see link below), I pointed out EV/IC (invested capital) as the appropriate measure for price to book value in capital intensive industries. Three airlines – Ryanair, easyJet and Southwest – with relatively young fleets, similar in age to what Air Canada’s fleet age is now, were trading at forward EV/IC multiples at more than 2.0 times, and a case was made that Air Canada should achieve similar multiples in the coming years having adopted a longer-term strategy on capital formation.
https://stockhouse.com/companies/bullboard?symbol=t.ac&postid=33080758 “Economic Value Added or EVA is operating profit less the cost of all the capital employed to produce those earnings. EVA is different from return on invested capital because it considers both the return on capital and the magnitude of the investment. EVA is the only performance measure to tie directly to intrinsic market value. EVA (trumps) every other financial performance measure, including cash flow. However important cash flow may be as a measure of Value, it is virtually useless as a measure of performance. So long as management invests in rewarding projects – those with returns above the cost of capital – the more investment that is made, and therefore the more negative the immediate cash flow from operations, the more valuable the company will be. It is only when it is considered over the life of a business, and not in any given year, that cash flow becomes significant.” (G. Stewart III, Stern Stewart)
While North American markets were focused on short- to medium-term results, longer-term investors who understood EVA waited patiently as Air Canada’s leadership took a longer-term view and renewed its fleet.
Recall from the previous post, ROIC – the key value driver – is the companion variable to EV/IC, the variable that dominates the multiple. For S&P 500 companies, 71 percent of the changes in EV/IC performance is explained by ROIC. Other variables include reinvestment rate, weighted average cost of capital and growth.
Consider Air Canada’s five-year performance from 2014-2018, averaged into one year, a period involving the highest dollar amount in capital expenditures.
Invested Capital: $10.7 billion
ROIC: 14.7 percent
WAAC: 8.6 percent
Net Debt: $6.1 billion
On average, Air Canada earned $642 million annually in economic profits with a ROIC six percent above its cost of capital on an average capital base of $10.7 billion (while reducing its leverage ratio from 3.1x to 1.6x). Over the five years, $3.2 billion in economic profits was added to the capital base of $10.7 billion. Value of operations (invested capital and economic profit) is $13.9 billion. Subtracting net debt of $6.1 billion results in an equity value is $7.8 billion.
The EV/IC linear regression model Credit-Suisse introduced in the above-mentioned report, suggests a 14.7 percent ROIC should generate an EV/IC multiple of 1.4 times. Applying this multiple to the five-year average invested capital base implies an average Enterprise Value of $15 billion (1.4 x $10.7 billion). Subtracting net debt results in an equity component of $8.9 billion.
Yet, the actual EV/IC multiple for this five-year period was only 1.03x, or an Enterprise Value of $11.3 billion (1.03 x $10.7 billion). Air Canada’s five-year average market cap was about $5 billion. Actual EV/IC multiples for the five years is as follows: 2014 (1.03x); 2015 (1.0x); 2016 (1.02x); 2017 (1.06x) and 2018 (1.06x).
Why did this mismatch occur?
Between 2014 and 2018, AC capex/sales averaged 14.5 percent, significantly higher than (for example) Delta Airline’s percentage spend. In 2014 and 2015, Delta’s capex/sales averaged 5.8 percent. Although Air Canada generated a five-year free cash flow/sales of 2.4 percent, average free cash flow was negative for the first three years in this period. Meanwhile, Delta’s 20.7 percent ROIC and low capex in 2014 pushed its free cash flow/sales percentage to 7.1 percent and EV/IC multiple to 2.1x. By 2018, Delta’s ROIC had fallen as its annual capex/sales surpassed 11 percent, but still well below Air Canada’s five-year average.
Reinvestment rate is the portion of the numerator in the ROIC calculation that is reinvested into the business. For a given growth rate, the higher the ROIC, the lower reinvestment rate, and the higher the free cash flow. Likewise, for the same growth rate, the lower the ROIC, the higher the reinvestment rate, and the lower the free cash flow. Between 2013 and 2018, Air Canada’s reinvestment rate was high as the airline renewed its fleet. Air Canada’s forward EV/EBITDAR multiple averaged 4.0 times throughout this period, highly discounted from its U.S. peers. This was to be expected as the companion variable for EV/EBITDA is reinvestment rate. Going forward, expect Delta and United to experience relatively lower EV/EBITDA multiples as these airlines update their fleets, while Air Canada’s EV/EBITDA trades at much higher multiples in view of its lower reinvestment rate.
Throughout this period, fleet renewal and growth suppressed ROIC and free cash flow generation and slowed debt reduction. It is worth noting Air Canada completed this growth and fleet renewal program without a lucrative loyalty program in place, unlike Delta and other U.S. carriers. For taking a longer-term view and re-fleeting early on, Air Canada’s share price performance was a laggard in the industry.
Aeroplan – The Gift that Keeps on Giving
In early 2019, a Joint Venture involving Air Canada and its financial partners completed the Aeroplan acquisition (from Aimia) including a cash infusion of $1.6 billion from the financial partners. Armed with an industry leading loyalty arrangement, and despite the B737 Max grounding, related revenue loss and higher costs, the airline was still able to generate an EBITDA margin of 19, ROIC of 15.5 percent, free cash flow of $2.08 billion, and achieve a leverage ratio of 0.8 times.
The significance of this transaction cannot be overstated. The in-house loyalty program significantly improves Air Canada’s future returns on capital, and it is these higher returns on capital that will translate future revenues and revenue growth and earnings and earnings growth into higher cash flows, and ultimately higher valuations.
Using a weighted average cost of capital of 7 percent (Air Canada’s estimated cost in 2019, industry is 7 to 9 percent) and four percent growth, increasing ROIC from 16 percent to 20 percent increases the value of a company by a factor of 33.3 percent, for any dollar amount of invested capital. The larger the capital base, the larger the 33.3 percent change, and the greater the company’s value. This is the essence of Air Canada’s share price performance in future years.
2014 Performance
In Measuring Air Canada’s Turnaround Success (see link at the end of this post), it was the older, wiser fish having learned to see and understand the broader context of his world – the Water – whose question prompted the younger fish – trapped in rational thinking with its narrow focus – to respond, ‘What the hell is water?’ It is the familiar that usually eludes us. What’s before our noses – for example, a turnaround – is what we often ‘see’ last.
Investors who have an expanded time frame can notice underlying patterns that only emerge over an extended period. An ability to identify trends early and be alert to opportunities are key qualities for long-term wealth creation. Seeing things in relation to time, so that the past is held as an important part of what has happened, the future is vivid, and the current situation is brought into consideration – a kind of fluidity of movement – is a skill that can be developed (the history of capital cycles is a key concept to understand). Oct 8, 2021, Blind Spots post
From the Credit-Suisse’s linear regression model used to identify EV/IC vs ROIC mismatches, a 20 percent ROIC should generate an EV/IC multiple in the 2.0 times range.
The following 2014 financial and valuation information was collected from Morningstar, analysts’ reports, and company annual reports.
Airline Lev Ratio Capex/Sales Ebitda Mar ROIC FCF/Sales EV/IC
Ryanair < 1.0 10% 22.1% 19.5% 10% 2.6x
EasyJet < 1.0 9.8 22.1 20.5 5.5 2.4
Southwest < 1.0 9.8 15.4 21.2 5.8 2.5
Air Canada 3.1 11.3 12.6 12.1 -4.1 1.03
In 2014, all three (low cost) airlines were generating similar ROICs but enjoying much
higher EV/IC multiples. Healthy free cash flows appear to be the differentiator. ROICs were high enough to sustain relatively robust capex programs while still delivering strong free cash flows. Most notable is Ryanair’s high FCF/Sales percentage (10 percent) resulting in the highest EV/IC multiple. A lower reinvestment rate, allowing more free cash flow to be generated, is clearly the other value driver enhancing the EV/IC multiple.
Balancing margin expansion, cash flows, fleet renewal and growth while maintaining capital discipline and manageable debt levels is more art than science. In 2012, Ryanair’s fleet growth levelled off and resumed only in 2016. In the ensuing years, the airline increased its margins and free cash flow eventually pushing EV/IC to 4.0x as it continued to grow and update its fleet. EasyJet, on the other hand, continued with an aggressive growth/fleet renewal trajectory throughout the same period eventually faltering due to compressed margins and much higher capital expenditures. Both airlines have fleets averaging 7 years in age.
2024 Performance (Est):
Aletheia (Ancient Greek): unconcealedness, disclosure, revelation, or unclosedness. The state of not being hidden, the state of being evident. It is the opposite of “lethe” which literally means concealment, forgetfulness or oblivion, a state of being unaware of what is happening.
In 2024, Air Canada’s invested capital will be about $14 billion, compared to $8.3 billion in 2014. ROIC in 2024 should be at least 20 percent compared to 12.1 percent in 2014. Weighted average cost of capital in 2024 will be 7 percent (or less with investment grade) compared to 10.1 percent in 2014, meaning about 13 percent (ROIC – Cost of Capital) will be applied to the 2024 capital base vs 2.1 percent to the 2014 capital base. Air Canada’s 2024 growth rate is assumed to be 4 percent, so same year’s reinvestment rate will be about 20 percent (4 percent growth/20 percent ROIC). In 2014, reinvestment rate was greater than 100 percent (growth rate exceeded a comparatively low 12.1 percent ROIC, capex/sales was 11.3 percent, free cash flow was -$547 million).
Air Canada’s similar ROIC but significantly higher free cash flow/sales percentage (18 percent) than Ryanair’s, and more than three times the percentage Southwest and easyJet generated should push its EV/IC higher than 2.5 times. Importantly, higher margins associated with sixth freedom traffic, Aeroplan and Cargo should push ROIC to even higher levels, meaning additional growth added will have a much larger impact on the Company’s valuation than growth that comes with a lower return on capital.
Higher ROICs + lower cost of capital + lower reinvestment rate + higher free cash flows will drive higher multiples
Airline Lev Ratio Capex/Sales Ebitda Mgn ROIC FCF/Sales EV/IC
Air Canada < 1.0 6.0% 22% 20% 18% > 2.5x
EV = 2.5 x $14B = $35 billion
Net Debt: $2 billion
Market Cap: $33 billion
Share Price: $92+
Assumptions for 2024:
1. Revenue is $20 billion (2019 revenue reached in 2023 + 4 percent growth, mostly sixth freedom traffic, loyalty, and cargo).
2. EBITDA margin is 22 percent. 2019 MD&A stated year-over-year increase in adjusted cost per seat mile (CASM ex-fuel) would have been 2.5 percent vs actual 6.1 percent had the Boeing Max not been grounded. Fuel CASM was also higher due to grounding of more fuel-efficient jets. Actual EBITDA would have been in the 21 percent range, rather than 19 percent. The one percent margin expansion is highly conservative considering high-margin sixth freedom traffic, loyalty, and cargo growth; at least 10 percent lower operating costs associated with fuel-efficient jets introduced after 2019; and other cost reduction initiatives completed during Covid-19. Additionally, capacity growth up until Covid-19 came at a higher cost. Post Covid-19, costs associated with capacity growth will have been removed.
3. ROIC assumption is conservative. Estimated 2019 ROIC would have been about 2 percent higher had the Max 8 not been grounded. Also, see my last post: making cents of Air Canada’s fleet. Air Canada's invested capital base should generate comparatively higher earnings compared to other airlines (more aircraft/seats per dollar of invested capital).
4. Cash flow from operating activities (CFO) is 1.10 percent of EBITDA, again conservative as
accelerated capital cost allowance and tax-loss carry forwards reduce cash taxes.
5. Capex spend is $1.2 billion (annual maintenance capex will vary between $1B and $1.2B, earnings call comment).
6. Free cash flow $3.6B ($20B Revenue x 22% EBITDA = $4.4B, CFO: 1.1 x $4.4 = $4.8B, FCF: $4.8B - $1.2B = $3.6B).
7. Accelerated debt reduction due tax-loss carry forwards, lease returns, and growing free cash flows from 2022 to 2024. Estimated net debt at year-end 2024 should be no more than $2 billion.
Valuation Crosscheck
Price to Free Cash Flow
To arrive at a price to free cash flow multiple, the average of the actual trailing 12-month multiple for Delta and United in 2019, 13.5 times, was applied to Air Canada’s 2024 free cash flow estimate of $3.6 billion. Year-end share price is estimated at $130 (13.5 x $3.6 billion/357 million shares).
2024
Market Cap $47 billion
Share Float 357 million
Share Price $130
A conservative trailing price to free cash flow multiple of 10x would still generate a share price of $101 ($3.6 billion x 10/357 million). $One-O-Wonder
Teras (Ancient Greek): the Greek word teras literally means ‘wonder.’ It refers to something that evokes astonishment or amazement in the beholder. It is usually understood as something that is likely to be observed and kept in one’s memory because of its extraordinary character.