Measuring Air Canada’s Turnaround SuccessTwo young fish encounter an older fish while out for a swim. “Morning, boys, how’s the water?” the older fish asks. The younger fish swim on for a bit, then one looks over at the other and says: “What the hell is water?” David Foster Wallace (This is Water)
In life, business, and investing the person with the fewest blind spots win. What keeps us from gaining valuable insights is our tendency to get too caught up in ourselves without seeing the most important and relevant realities around us. This lack of awareness is further complicated by flaws in our mental circuitry that prevents us from noticing slow, incremental changes – both good and bad – and keeps our default-setting for ‘time horizon’ comfortably in the short-term.
These shortcomings hinder us as investors especially when it comes to identifying
and following corporate ‘turnarounds.’ We often fail to notice the signals that begin a turnaround, and even if we do, we rarely commit the time to understand a ‘play’ that will typically take a decade, or more, to playout. Cleaning up a balance sheet is a slow process. Achieving material cost savings take time and usually requires technological innovation. Successful strategies demand new ways of thinking and take years to execute, often requiring fine-tuning along the way. In developing a deeper understanding of an industry investors quickly come to know which leaders see the way forward to eventual success, and others that don’t
– leaders who are lulled into complacency by their past success.
Air Canada has been in ‘turnaround’ mode for over ten years now, and it continues. For many current investors, their investment in Air Canada has only been recent. For others, only in the last two or three years have they been invested, largely because of increasingly favourable and frequent business media coverage of the Company.
Last week, IB1temporary posted part of CIBC’s most recent report (see link below). The analyst examined the U.S. airline industry and concluded that the industry has become more profitable after every downturn over the last forty years.
The analyst’s final conclusion was that Air Canada too would exit this recession, a stronger and nimbler airline.
“we believe Air Canada is in a good position given its market position, the strength of its balance sheet heading into this crisis, its cost-cutting initiatives, and its operational adjustments. All of these factors should allow it to recover faster than its domestic peers. The recent launch of its revamped loyalty program also provides an additional earnings lever for Air Canada. In addition, as its financial performance begins to benefit from a recovery in air traffic, this also bodes well for Chorus Aviation as it reduces the risk around its Capacity Purchase Agreement (CPA) with Air Canada.” For the benefit of those investors who have recently jumped onboard, let’s compare the Air Canada of 2008/2009, as it exited the worst financial crisis since the Depression, with the Air Canada of today, an airline about to exit a very different kind of crisis, a crisis that has impacted the industry more than any other event over the last 90 years.
Fixing the Pension Problem Defined benefit pension plans are anathema to airlines, at least to Canadian airlines with this kind of plan. Why? The financial health of these plans is highly sensitive to changes in interest rates. The higher the interest rate, the better it is for the pension plan; however, the lower the rate, even relatively small changes in the rate, can have a damaging effect. For example, ten years ago, Air Canada’s pension plan had total assets exceeding $10 billion. A one percent decrease in the interest rate resulted in pension liabilities increasing by $1.7 billion. Unlike U.S. rules that allow companies more than 15 years to remove the deficit, Canadian federal solvency funding requirements are much stricter requiring deficits be removed within five years. Additionally, OSFI (the federal pension administrator) requires defined benefit plans use a lower discount rate (a government rate) than that allowed in the U.S. (corporate rate) when determining future obligations.
In economic downturns, interest rates are brought down, often dramatically, to kick start the recovery. For Air Canada, falling rates caused significant margin compression as the airline experienced not only a declining revenue environment but also a significant jump in pension funding requirements. The U.S. carriers are not subject to this phenomenon because of less stringent rules.
In 2008, Air Canada’s pension funding obligation for its $2.8+ billion solvency deficit was $456 million, or 4.7 percent of total revenue. Following his appointment in 2009 to President and CEO, and after restructuring the Company’s capital, Calin Rovinescu began tackling the pension problem. His first step was to seek an extension from OSFI, from five years to 10 years, to allow time to bring about the needed structural changes to the plan. Over the next few years, several significant changes were made including reducing pension benefits, increasing mandatory retirement age, re-working retirement formulas, and closing the defined benefit plan to new employees. By 2015, the Company had improved its solvency position by more than $5 billion, reporting a $1.2-billion surplus. The plan was eventually immunized to approximately 75 percent, significantly reducing interest rate risk going forward.
In 2019, total employer defined benefit pension funding contributions was $109 million, or 0.57 percent of total revenue, a significant reduction in annual expense when compared to 2008’s funding obligation of $456 million representing 4.7 percent of revenue. As of July 1, 2020, the aggregate solvency surplus in Air Canada’s domestic registered plan was $2.5 billion.
This compares favourably to the Airline’s three U.S. counterparts (Delta, United and American) all still burdened with significant pension deficits requiring on-going periodic payments that will suppress future free cash flow.
Fixing the Cost Side (Up-gauging Strategy) Exiting the 2008 financial crisis, Air Canada’s narrow body fleet comprised 131 aircraft. The average seat count for the 131 fins was 123 seats, the lowest, if not
the lowest in the NA market. (There were actually 146 fins but the smallest 15
– the Embraer E175s
– were transferred into the feeder network.) Between now and 2023, the narrow body renewal program, which began in 2017, will be completed with the remaining firm orders of Boeing B737 Max 8s and Airbus A220s delivered. By then, the average seat count for the mainline narrow body fleet will be 158 seats, an average seat count that is 28.5 percent higher than it was in 2009.
Stated differently, on the recovery side of this recession, Air Canada’s mainline will operate 21 fewer narrow body aircraft but will be able to carry 1,355 more passengers than it did exiting the 2008 recession. If we include the Rouge fleet (average seat count of 164), the Airline as a whole will operate 144 narrow body aircraft comprising 23,089 seats. When compared to 2008, the Airline will carry 43.3 percent more passengers exiting this crisis with only 10 percent more narrow body aircraft.
While this improvement in productivity for the narrow body fleet is indeed impressive, it is equally impressive when fuel consumption is considered. The Embraer E190 has a 39 percent higher fuel consumption per seat, and the Airbus A319, a 17 percent higher fuel consumption per seat than the Airbus A-220, the airplane that is replacing these two older types. Likewise, the older Airbus A320 has a 37.5 percent higher fuel consumption per seat than the B737 Max, the aircraft replacing it. It is the 15 percent more fuel-efficient engines in combination with new, larger airplanes with much higher seating density that enables this magnitude in fuel savings.
It’s a similar story for Air Canada’s wide body fleet. In 2009, the average seat count for the long-haul fleet was 249. Today, the average seat count is 322, an almost 30 percent increase. This increase also came with the introduction of the much more fuel-efficient Boeing B787s, as well as a seat densification program for the remaining wide-body fleet.
These improvements are further enhanced when average stage length (ASL) is factored into the equation. Increasing ASL yields additional savings. Between 2013 and 2018, Air Canada’s ASL increased by about 19 percent, while the ASL for its U.S. counterparts remained unchanged.
Aircraft utilization also increased. In 2009, average aircraft utilization was 9.2 hours per day while in 2019, average utilization was 10.6 hours per day, a 15.2 percent increase. Airport and navigation fees in 2009 represented 9.97 percent of total revenue; but by 2019, these fees represented only 5.17 percent of total revenue.
In terms of employee productivity, flying larger aircraft with higher seating density over longer distances significantly improved employee productivity (much higher than its U.S. counterparts). These metrics will continue to improve as the remaining narrow body aircraft are delivered:
Available Seat Miles (ASMs) per Employee 2009 2,091,000
2019 3,428,000
Change +64%
Passenger Revenue per Employee 2009 $425,000
2019 $581,000
Change +37%
Beyond the up-gauging strategy, Air Canada sought other improvements that will favourably impact its return on capital going forward. Two notable ones were a move away from aircraft leasing and financial (and other) improvements to its capacity purchase agreement with Chorus Aviation.
- By end-2018 (accounting rules changed for leases in 2019), aircraft rent represented only 2.4 percent of total revenue, down from 3.44 percent in 2009. This percentage will continue to fall as the Company parks 79-older aircraft, the majority of them leased. For perspective, aircraft rent charges in 2003, the year the company entered into bankruptcy protection, represented 12 percent of total revenues! Leases adversely impact ROIC, negatively affecting both numerator and denominator. The move towards ownership also allowed the airline – and not the lessor – to fully benefit from volume discounts on fleet purchases.
- Air Canada amended it capacity purchase agreement with Chorus, its feeder airline. The estimated NPV is $275 million (2019 to 2025). This agreement, which includes a $97 million equity investment, provides significant network benefits and improvements.
For more background on some of the areas discussed in this section, see two of my previous posts, both of which references McKinsey’s Pathway to Value Creation.
The Race for Efficiency
Resolving the Asset Dilemma
Growing Premium Revenue
An Evolving Value Proposition
Competing to be unique thrives on innovation. Air Canada’s value proposition has changed considerably since 2008. De-bundling of fares, new and innovative product offerings with an emphasis on premium products, increasing market breadth through international expansion and an expanding STAR Alliance network, the formation of Joint Ventures, a young fleet operating out of Hubs with geographical advantage, and a soon to be launched industry leading in-house loyalty program will enable the Airline to create superior value and drive a wider wedge between buyer value and cost than its rivals are able to.
This section provides an overview of the changes that have occurred over the last decade. A much larger portion of Air Canada’s revenue is now generated by more diverse, higher-margin revenue streams, and the Company will continue to focus on this area of growth.
Ancillary Revenue
Over the last 10 years, one element of Air Canada’s basic value proposition has shifted from all-inclusive to seat only. This change has enabled the Airline to capture additional ancillary revenue. At the 2019 Investor’s day, it was reported that unbundling has enabled ancillary revenue to grow 13-14 percent annually through upselling, the key drivers being cabin upgrades and preferential seat fees. Expect this growth to accelerate under the new Aeroplan program and with growing sixth freedom traffic.
Premium Economy
Another change to Air Canada’s value proposition is increased premium product offerings. Air Canada was the first NA carrier to introduce premium economy seating, and it has become a cash cow for the Airline. Executives at American Airlines have reported the average fare for its premium economy product is twice the economy fare making it the most profitable use of square footage on their widebody aircraft. Premium economy cabins typically offer wider seats with more legroom than standard economy, as well as more perks such as larger in-flight TV screens and upscale meals.
Airlines offering premium economy typical charge as much as 80 percent more than an economy ticket for a product that takes up only slightly more space and does not cost the carrier much more to produce. The demand for premium economy has increased partly because economy class has become increasingly cramped. It likely also grew out of the last financial crisis when business travellers downgraded from business to economy as a cost-savings measure. Air Canada introduced its premium economy in 2013. The U.S. carriers – American, Delta and United – are late to this game, having only recently started introducing premium economy cabins across their wide-body fleets.
Click on the link below and read about one customer segment who will be looking to use premium economy (or business class).
Sixth Freedom Traffic
Revenue from flying international travellers (mostly U.S. citizens) through its three international Hubs in 2009 was insignificant, compared to the sixth freedom revenue that the company was generating prior to the MAX 8 grounding, the airplane that is playing a key role in developing this traffic. From last Investors’ Day presentation, Air Canada currently has about 1.3 percent of the higher margin international transit traffic to/from the US, and its initial goal is to reach 2 percent in the next few years, representing about $700 million in additional incremental revenue. International transit traffic increased 142 percent between 2013 and 2018, with 2017-2018 experiencing year-over-year growth of 15 percent. The new Airbus A220 aircraft will also play a role in developing this traffic, opening up new routes to/from the United States.
Joint Ventures (JVs)
Immunized JVs are partnerships between two or more airlines that typically involve collaboration in areas such as schedule coordination and revenue sharing. For travellers, JVs mean seamless travel with more options to the same destination and to a greater number of travel destinations. For airlines, JVs enable them to increase their revenue on a number of routes they themselves do not operate. For airlines (and investors), an airline within a JV benefits from less competition and greater pricing power. Ultra low-cost carriers like Norwegian Air complain that JVs are anti-competitive. While this point is arguable, two carriers, such as Air Canada and Lufthansa, coordinating schedules and sharing revenue is less competitive than the two carriers competing against each other on the same routes.
Air Canada’s first JV (Atlantic ++) was formed in 2009 with United, Lufthansa (and later Austrian, Swiss and Brussels Airlines). By end-2019, this JV encompassed 10,000 daily flights to 570 destinations. In 2018, Air Canada and Air China signed the first JV agreement between a Chinese and North American airline. The JV enables the two flag carriers to expand their existing codeshare relationship, increasing the number of Canada-China connecting flight opportunities for customers by 564 each day. The two carriers now operate up to a total of 52 trans-Pacific flights per week between Canada and China.
Revenue Management
Air Canada’s revenue management system in 2009 focused on maximizing route profitability, rather than network profitability. Airline revenue management is a complex business. Within the last five years, Air Canada introduced a much more sophisticated revenue management system that allows the airline to optimize passenger flows across its network. In terms of revenue enhancement Company executives will only say the immediate impact was over $100 million. Expect further improvements in revenue optimization as the company grows sixth freedom traffic and transforms Aeroplan.
Higher Load Factors
Expect load factors to average higher once recovery begins in a meaningful way. In 2019, the average load factor for the three U.S. legacy carriers had reached 85.7 percent (Delta’s was 87, American was 86 and United, 84). In 2009, the U.S carriers averaged 82 percent. In 2009, Air Canada’s load factor was 80.7 percent whereas in 2019 load factor had increased to 83.4 percent.
There are a couple of reasons for the lower percentage when compared to the U.S. carriers. First, most of Air Canada’s capacity increase over the last seven years is the result of international expansion. New routes have lower load factors than mature routes. Secondly, having outsourced its loyalty program in 2003, Air Canada was at a disadvantage in managing its capacity during the less busy quarters. With these constraints removed, reduced capacity in the market and a new Aeroplan program in place, expect to see higher load factors similar to the three U.S. legacy carriers going forward. Applying the U.S. legacy carriers average load factor of 85.7 percent to Air Canada’s 2019 pricing structure would have increased revenue by $480 million.
Aeroplan II
Carriers no longer care “whether they sell a seat with dollars or miles,” said Jay Sorensen, IdeaWorks president. “Historically it was negative from a revenue standpoint if they sold a seat with miles in general. Now airlines are recognizing that these loyalty programs are tremendously valuable.”
Without doubt, the most significant change since 2009 has been the repatriation of Aeroplan. My August 30th post gives you an idea of the huge upside in revenue this change brings to Air Canada’s revenue picture. Aeroplan II will offer new and existing eligible Aeroplan cardmembers a wide range of improvements in Air Canada travel benefits. Moreover, expect a U.S credit card to be introduced in the near future, which will capture additional revenue for the Airline. Fifteen percent of all international travel by U.S. citizens is to and from Canada.
According to Industrial Alliance Securities, ‘Aimia paid Air Canada $700 million in 2015, while Air Canada, which buys miles to give its frequent flyers under Aeroplan, paid Aimia $245 million the same year’ (Bloomberg). With Aeroplan back under Air Canada’s umbrella, the Airline no longer has to buy miles from a third party to give to its customers. While the offset is that Air Canada has absorbed Aeroplan’s operating costs, the Airline now has the flexibility to encourage not only redemptions during off-peak travel periods and economic downturns but also cardholders who fly infrequently to redeem points on air travel rather than on good and services (which still typically have 50 percent profit margins).
Air Canada – A Free Cash Flow Story
After exiting the financial crisis in 2008, and despite its higher cost structure and large pension payments, Air Canada was still able to generate over $1.3 billion in free cash flow before embarking on a $12 billion capex program in 2013 that would see the Airline renew both its wide-body and narrow-body fleet. The wide-body fleet renewal program was completed in 2018 and the narrow body program will be completed over the next 2-3 years.
The Airline currently has 24-Boeing B737 Max aircraft grounded and, when the aircraft is re-certified, will take delivery of another 26 aircraft in the next couple of years, for a total of 50 aircraft. Likewise, by year-end, 15-Airbus A220s will be in the fleet, with 30 more deliveries planned, for a total of 45 aircraft.
In a previous post, I estimated that the acquisition cost per fin for the Boeing MAX 8 was about $56 million, and about $46 million for the Airbus A220. Assuming these aircraft are delivered between 2021 and first half 2023, total projected committed expenditures over the 30-month should be as follows:
26 Boeing Max 8 @ $56.4 million = $1,466 million
30 Airbus A 220s @ $46.3 million = $1,389 million
Total Committed Expenditure: $2,855 million
What has not been accounted for, however, is the agreement reached earlier this year between Boeing and Air Canada that compensates the airline for loss revenue and additional costs incurred as a result of the MAX grounding. Here is an excerpt from the latest MD&A:
“Air Canada has concluded its discussions with Boeing to settle the terms of an arrangement in relation to the grounding of the Boeing 737 MAX aircraft. The settlement payments contemplated by the arrangement were made to Air Canada during the fourth quarter of 2019 and during the first and second quarters of 2020. The compensation is accounted for as an adjustment to the purchase price of current and future deliveries and will flow through Air Canada’s consolidated statement of operations as reduced depreciation expense over the life of the aircraft, and as a reduction to additions to property and equipment on the consolidated statement of cash flow. “
While a small part of the settlement was paid in 2019, most will be paid in either a combination of cash and other in-kind considerations, or possibly all in in-kind consideration; in other words, significant discounts on future deliveries. From Boeing’s perspective and in light of Covid-19, the manufacturer would want to preserve cash and therefore likely incentivized airline customers to accept less cash and agree to attractive discounts on future aircraft deliveries. The Company in settling the terms of the agreement would also be looking to reach an agreement that would minimize taxes paid, and may have agreed to take in-kind consideration, particularly if it increased the size of the settlement. The agreement will be kept confidential, but for the purpose of determining free cash flow estimates below, I am going to assume the Company took all its compensation in in-kind consideration, meaning discounts on future deliveries.
It should be noted that sell-side analysts will not be factoring the Boeing settlement into their future cash flow projections because they don’t have any visibility on the agreement. The result will be lower free cash flow and higher net debt projections.
In an earlier post, I estimated that the total settlement should exceed $1.1 billion, and with a small portion paid out in late 2019, the remainder of the settlement is likely in the $800 to $900 million range, or more. This works out to about 16-B737 Max 8 aircraft that will be delivered at no cost to the corporation. This reduces the total committed expenditure to just under $2 billion over the three-year period ($2.855 billion - $900 million).
In the revised Capital Commitments table listed below I assume that the 16 Max aircraft will be delivered in 2021 as the Airline recovers and grows its operating cash flow, and will want to return to generating free cash flow as quickly as possible. I assume the heaviest capex year will be 2022. Twelve A220s will be delivered in 2021, fourteen in 2022 and four in H1 2023. The ten remaining B737 Max 8s would be delivered in 2022. Planned committed expenditures in 2023 remain unchanged at $189 million.
(Canadian dollars in millions) 2021 2022 2023
Projected committed expenditures (revised) 555 1,200 189
Projected planned but uncommitted exp. 463 486 652
Projected planned but uncommitted
capitalized maintenance 324 415 407
Total Expenditures 1,342 2,101 1,248
Using S&P Capital IQ consensus EBITDA for 2021 to 2023 and adding 10 percent to arrive at an operating cash flow (average accelerated write-off, etc.), then the free cash flow estimates for this three-year period are as follows:
(Canadian dollars in millions) 2021 2022 2023
Operating Cash Flow 2,167 2,912 3,115
Total Expenditures 1,342 2,101 1,248
Free Cash Flow 825 811 1,867
(Future tax losses are not factored into these calculations.)
Key Points:
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Using 2021 S&P consensus data, revenue of $12 billion (63 percent of 2019 revenue) and a 16 percent EBITDA margin, Air Canada is able to generate free cash flow next year assuming the capex scenario presented above.
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Using 2023 S&P consensus data, revenue of $16.6 billion (87 percent of 2019 revenue), a 17 percent EBITDA margin, free cash flow of $1,867 million and the 2019 trailing twelve-month FCF multiple of 9.3x, Air Canada’s share price should be $58.
(See my previous post for my share price estimates for 2023.)
How Will Covid-19 Change the Mindsets of Airline Leaders?
An interesting question. Let’s look at how their thinking has changed over the last 15 years.
Oil prices rising to $140/barrel in 2008 caused airline leaders to re-think how they deployed and managed capacity. One obvious consequence was the need for engine manufacturers to design more fuel-efficient engines. But they also recognized that the path to future profitability and importantly greater cost stability was to adopt an up-gauging strategy and increase average stage length – flying larger aircraft over longer distances. Not easily done, as fleet transformation often takes decades to accomplish.
Following the financial crisis in 2008 and a slew of airline Chapter 11 filings, large institutional funds – like Vanguard, Blackrock, Primecap, State Street – began taking significant ownership positions in the U.S. airlines and with that, an encouragement to focus on return on invested capital.
Although ROIC is a common financial measure, in the airline industry returns on capital were so poor it didn’t make sense to talk about it. The priority for airline CEOs had been on improving liquidity, getting to positive free cash flow and reducing debt, and costs. It’s only been in the last 7 or 8 years that airlines began setting targets around ROIC and achieving them, which in turn created shareholder value and led to higher share prices. With up-gauging and capacity strategies already part of their thinking, returns on capital could be further increased through seat densification, product segmentation and choosing aircraft ownership over leasing.
This ROIC mindset continued to playout when the most recent fuel price spike occurred. Fewer airlines are entering into fuel hedges with the goal of using it as a strategy to gain a cost advantage over other airlines when fuel prices subsequently rise. Southwest used this strategy to their advantage in 2008 to gain market share. When oil prices increased to $140/barrel, the airline kept fares low forcing its competitors to move many of their wide-body aircraft into international markets where yields were higher. This didn’t occur in 2018 when jet fuel prices spiked over 50 percent from a year earlier. North American airlines used the increase cost in fuel as an opportunity to raise fares.
The Boeing MAX grounding in 2019 resulted in unplanned tighter capacity in the North American market which put upward pressure on passenger yields. For Air Canada, year-over-year increase in yield was 4.6 percent. The tighter capacity enabled the Airline to keep yields higher even though the price of oil had fallen in the latter part of 2018.
I mentioned in a previous post that if the current crisis causes the four large U.S. carriers to cut their capacity by 20 percent over the next year, then their combined capacity will be at the same level as it was in 1997, a time when the U.S. population base was about 17% smaller.
With a ROIC mindset firmly embedded in their thinking, airline CEOs are going to be aggressive in removing costs as they prepare to exit this crisis. Once a meaningful recovery is underway, they’ll be looking to drive ROIC up (tighter capacity and much higher fares?) in order to generate the strong cash flows needed to drive down leverage ratios and fund fleet renewals.
While Delta entered the crisis with the best liquidity ratio of the three U.S. legacy carriers, the airline is only in the early part of its second of three phases of its fleet renewal program. The airline recently pushed out a large number of planned deliveries extending its second phase (and delaying its up-gauging strategy) well into the future. American Airlines, on the other hand, entered the crisis with the youngest fleet of the three U.S. carriers, but also with the highest leverage ratio. Its net debt was $20 billion ($40 billion including its pension solvency deficit) pre-covid19 and has since increased substantially.
With impressive revenue generating capabilities ahead, significant past and ongoing cost reductions, a re-structured pension plan with an aggregate solvency surplus, one of the best liquidity ratios globally, its fleet renewal program almost complete, a Boeing settlement in hand, Air Canada will be exiting the Covid-19 crisis with the capacity to generate strong cash flows enabling the Airline to accelerate debt repayment and earn an investment grade rating by year-end 2023. The Airline is set to outpace its competitors.
So, how’s the water?