Re-post to correct a couple of typos. One typo made reference to 6th freedom traffic to/from U.S. destinations. The 'high margin' traffic was omitted.
The following is an updated valuation for year end-2025 based on the most recent announcements, including the decision not to acquire Air Transat and additional liquidity and share dilution resulting from the Liquidity Program agreement reached earlier this month with the Federal Government.
Highlights of this agreement as they pertain to this post are as follows:
- An equity infusion of $500 million as well as additional warrants at stated exercise prices. The immediate equity infusion is likely to be used to retire a USD $400 million senior unsecured note at 7.75 percent due this month. For the purpose of calculating future value in this post, a 10 percent share dilution is assumed (shares and warrants).
- Substantial additional liquidity, in the form of loans, most of which are at favourable rates, to be added to the 2020 year-end liquidity level of just over $8 billion. I do not expect any of the higher interest tranches will be used.
- “The completion of the airline's acquisition of 33 Airbus A220 aircraft, manufactured at Airbus' Mirabel, Quebec facility. Air Canada has also agreed to complete its existing firm order of 40 Boeing 737 Max aircraft. Completion of these orders remains subject to the terms and conditions of the applicable purchase agreements.” These aircraft were always coming. Most of the remaining 16-Boeing B737 MAX8s will likely come at no cost to the company, as it formed part the Boeing compensation package resulting from the MAX grounding.
- Restrictions on dividends and share buybacks.
The removal of the USD high-interest (7.75 percent) unsecured note this month, combined with low interest loans in $CDN will have a favourable impact on Air Canada’s annual interest charges, foreign exchange and interest rate risk, and weighted average cost of capital (WACC). Most of the remaining $1.24 billion debt maturing in 2021 is older, higher interest notes, in the 8 percent range, and in USDs, so this will push the weighted annual interest rate, currently at 4.36 percent, to under 4 percent. At the end of 2019, Air Canada estimated its WACC at 7 percent. After recovery from Covid, Air Canada should see its cost of capital fall below 7 percent, as the older more expensive debt is refinanced at lower rates, and even lower when an investment grade rating is awarded in 2023 (different calculation for investment grade companies).
In my Jailbreak! post (see link below), a valuation was placed on Air Canada’s loyalty program using the same methodology U.S. financial institutions used to valued airline loyalty programs in 2020. My valuation included Air Transat card membership and a lower share count.
https://stockhouse.com/companies/bullboard?symbol=t.ac&postid=32771143 The updated loyalty valuation is as follows:
Aeroplan’s estimated 2025 revenue stream and estimated share price based on current share count is as follows:
Canadian Cardholders: $5.30 bn
With JPMorgan Cardholders: $6.88 bn
Sales to Visa, Amex and Master Card (JPMorgan): $6.88 bn
Sales to Air Canada (49 percent of $6.88 bn):
3.37 Total Revenue: $10.25 bn
EBITDA (39.3 percent) $4.03 bn
Present Value (intrinsic) of
Aeroplan based on 2025 estimated earning, 370 million shares outstanding and a conservative 12x EBITDA multiple: $130/share.
Present Value (intrinsic) of
Aeroplan based on 2025 estimated earnings, 347 million shares outstanding and a conservative 12x EBITDA multiple: $139/share. (See my scenario below for a revised share re-purchase schedule.)
Note: Using this valuation model necessarily reduces the value of the airline component of the business, as more revenue is apportioned to the loyalty valuation, and less to the airline.
At the end of the post, I commented that the market should eventually recognize the intrinsic value of airline loyalty programs – particularly lucrative ones like Air Canada’s – with higher multiples. The following outlines my thinking.
ROIC – The Key Value Driver If there has been a shift in corporate finance and valuation in recent years (mid-1990s), it has been towards giving “excess returns” (economic profits) a more central role in determining the value of a business. While early valuation models emphasized the relationship between growth and value – higher growth firms were assigned higher values – more recent iterations of these models have noted that growth unaccompanied by excess returns creates no value.
– Aswath Damodaran, Professor of Finance, NYU
In capital-intensive businesses, the foundational principle for success is to have a clear line of sight on how much profit (economic profit) over the cost of capital an investment will create. The most crucial measure is the ROIC, which measures how well management is able to generate an operating return per unit of invested capital. ROIC, a proxy for cash flow, is a measure of profitability and is the
key value driver.
Air Canada’s decision not to proceed with the merger is a signal to the market that management is placing more focus on ROIC than on growth exiting this crisis. Growth will still occur but will be diversified growth, enhancing rather than eroding ROIC.
The NA rail industry’s improving fortunes are the direct result of a focus on ROIC beginning in 2003. Improving margins and capital efficiency is largely attributed to operating longer trains with higher railcar capacity over longer distances. Advances in engine and computer technology – such as locomotives with distributed power systems, positioned in the middle of the train – enable longer trains to operate with less manpower. Today, ROICs for NA railroads average in the 14 -16 percent range, and the U.S. rail industry enjoys Price to Free Cash Flow multiples in the 25 times range while CN and CP enjoy multiples in the low 30s. With a weighted average cost of capital in the 6 percent range, the capital efficiency (ROIC/WACC) ratio for railroads is typically in the 2.5 to 2.7 range.
The focus on ROIC for the airline industry began ten years ago. Normally companies endowed with older assets in capital intensive industries, are typically able to generate windfall profits. However, in the airline industry, a strong inverse relationship exists between economic profits and average fleet age. For airlines, the primary drivers for improving ROIC is to fly larger, fuel-efficient aircraft over longer stage lengths, with increased seating density and through privileged hubs. Importantly, the recent shift in economic benefits from loyalty programs, away from the financial institutions and toward airlines, is playing an increasingly important role in ROIC improvement. With its fleet renewal almost complete, an industry leading loyalty program, and three privileged hubs drawing 6
th freedom traffic to/from the United States, Air Canada has a
significant and a unique advantage over other carriers.
EV/Invested Capital (IC) EV/IC is the appropriate measure of P/BV for capital intensive industries, and ROIC is the companion variable to this valuation model.
The importance of ROIC on earnings multiples can be seen by examining differences in ROIC between Asia and the United States. The median large US company earned 19 percent ROIC in 2013 while the median Asian company earned an 8 percent ROIC the same year. Asian companies have traditionally focused more on growth than on ROIC. The median EV/IC is 2.9 in the United States compared to 1.4 times in Asia. In terms of P/E multiples, US companies averaged a 21 times P/E while Asian companies average was 16 times trailing earnings.
For S&P 500 companies, a high correlation also exists between ROIC and EV. In a linear regression on EV/IC, 71 percent of the changes – a high percentage for a linear regression – is explained by ROIC. The other factors correlating with EV are growth, reinvestment rate, risk (WACC) and competitive advantage (how long ROIC remains above WACC).
Prior to this most recent business cycle, the main reason airlines were assigned low P/E and EV multiples, even during major growth periods, was due to low ROICs. The International Air Transport Association reported that from 1993 to 2013 the airline industry as a whole failed to earn a ROIC greater than its cost of capital. The median ROIC between 1965 and 1995 was 4 percent, and 6 percent from 1995 to 2013. The industry WACC is between 7 and 9 percent.
The value of a company is a function of not just its actual performance, but of expectations of investors about future performance. Suffice to say that for airlines, early in the last business cycle, expectations among most investors about future performance was low. Keep this in mind when examining the Credit Suisse observations, and the fact many of the carriers in the study were still focused on growth rather than ROIC.
In late 2014, Credit Suisse published a report on Global Airlines – EV/IC vs ROIC – using 2014 YTD numbers. The linear regression showed an almost consistent correlation between ROIC and EV/IC. For example, a 17 percent ROIC resulted in an EV/IC multiple of 1.7 times. A 20 percent ROIC resulted in an EV/IC multiple of 2.1 times. A 23 percent ROIC resulted in an EV/IC multiple of 2.5 times. Three carriers – EasyJet, Southwest and Ryanair – in 2014 were earning ROICs from just under 20 percent to 25 percent and all three airlines were seeing EV/IC multiples in the 2.4 to 2.7 times range.
The U.S. legacy carriers were earning ROICs in the 15 to 20 percent range and earning EV/IC multiples in the 1.5 to 2.0 times range. The majority of the remaining airlines, many of them Asian without a ROIC focus, are clustered in and around 10 percent ROIC with EV/IC multiples slightly below and above 1 times. Air Canada is not included in this study.
During a two-year period later in the cycle (2016-2017) when Southwest’s ROIC averaged 23.35 percent (EBITDA 22.45 percent) the airline earned an average P/E of 17.7 times, an average P/FCF of 15 times, and an average EV/EBITDA multiple of 7.2 times.
Q1-2020 is the last time Air Canada reported its invested capital, at $11.27 billion. Since then, eleven Airbus A220s were delivered, and older aircraft parked. However, over the next two years, the Company will take delivery of 16 Boeing B737 MAX aircraft and an additional 30 Airbus A220 aircraft. A reasonable estimate for invested capital in 2025 would be in the $14 billion range.
The Airline’s low re-investment rate, diversified revenue stream (steadier ROICs, non-core airline) and high free cash flow, combined with positive investor expectations, should have an additional favourable impact on the EV/IC multiple. That said, using Credit Suisse’s 2014 data, a 23 percent ROIC in 2025 should generate a 2.5 times EV/IC multiple, resulting in an EV of $35 billion, or a share price of $101, based on a year-end share count of 347 million.
Earlier I mentioned the NA railroad companies are achieving a capital efficiency typically in the 2.5 to 2.7 times range while enjoying Price to Free Cash Flow multiples above 25 times. In the next few years, Air Canada should earn a capital efficiency ratio around 3.3 times its cost of capital (23 percent ROIC/7 percent WACC). This ratio is also a measure of a company’s competitive advantage.
Price to Free Cash Flow The following is sourced from a document produced by TD Securities in December 2019:
- For twelve U.S. based industrial companies, the average forward Price/Free Cash Flow multiple was 20.3 times with an average ROIC of 17 percent.
- For four global air carriers – International Airline Group (British Airways), Air France-KLM, Qantas, Lufthansa – the average forward Price/Free Cash Flow multiple was 11.8 times with an average ROIC of 10 percent.
- For Delta and United the average forward P/FCF multiple was 11.7 times with an average ROIC for the two companies of 17 percent. American’s high leverage ratio (4.1x) was considered an outlier and removed.
A review of the
actual Price to Free Cash Flow multiples (trailing 12-month) for the two airline groups reveals the following:
- For the four global carriers, the average Price to Free Cash Flow multiple was 13.9 times.
- For Delta and United, the average Price to Free Cash Flow multiple was 13.5 times.
For Air Canada, the trailing 12-month Price to Free Cash Flow multiple was only 7.6 times. Air Canada’s 2019 ROIC and EBITDA margins were adversely impacted as a result of the 24-Boeing B737 MAX aircraft grounded, impacting 9 percent of its total fleet. Of the above-mentioned airlines, only United was impacted by the MAX grounding, with 27 aircraft grounded representing 3.3 percent of its total fleet. Lease extensions enabled Air Canada to still fly 97 percent of its planned capacity in 2019, but the lower revenue came at a much higher cost (all eventually recovered from Boeing).
Actual results for FY 2019 included a ROIC of 15.6 percent and an EBITDA of 19 percent, two percent below what would have been achieved had the MAX not been grounded.
Given the much higher estimated ROIC between 2024 and 2026, Air Canada should see a share price based on (
at least) a 12 times forward Price to Free Cash Flow valuation. This forward looking multiple is just slightly more than that of the other airlines, seen in 2019. A more realistic multiple should be in the 15 times range, similar to Southwest’s multiples when that airline earned ROICs in the 23 percent range.
Here’s what a 12-times multiple will generate: The assumptions used to estimate Free Cash Flow between 2024 and 2026 are as follows:
Revenue: TD’s 2023 revenue estimate ($18.94 billion) is used, and a conservative five percent growth from 2024 to 2026 is added. Historical annual revenue growth is about six percent annually, which is also McKinsey’s estimate for the airline industry as a whole over the last 20 years.
EBITDA Margin and ROIC: For 2023, TD is currently forecasting an EBITDA margin of 21.4 percent, and a ROIC of 21.2 percent. Between 2024 and 2026, an EBITDA margin and a ROIC of 23 percent is assumed. This increase is due to growing 6
th freedom (higher margin) traffic to/from the United States; growing loyalty revenue from both Canadian and U.S. cardholders and increasing revenue from an expanding cargo operation involving freighter aircraft, both high margin contributions; and the remaining new narrow body aircraft (16-B737 MAX8s and 30-Airbus A220s) entering the fleet over the next two years offering substantially lower operating costs (greater than 10 percent) and higher density seating than the aircraft being replaced.
Cash Flow Estimates: Six percent is added to EBITDA values for all three years.
Capex: For 2024 to 2026, Air Canada’s estimated Capex is $1.4 billion annually, much higher than what is recorded for 2024 in the latest MD&A. This would allow for partial re-fleeting of Rouge with used, mid-life wide-body aircraft, likely Airbus A330s. Most of these used aircraft are available through leasing companies, so capex spend is overly conservative. Leasing rates for these aircraft are now dirt, dirt cheap for credit worthy airlines like Air Canada. (One leasing representative estimates there could be up to 100 of these aircraft available for lease.)
Investment Grade Rating: By end-2023, Air Canada should achieve an investment grade rating. (TD’s estimated leverage ratio for 2023 is 1.0x.)
For the purpose of the calculations below, the free cash flow generated in 2024 is assumed to be used to further reduce the (net-debt) leverage ratio to, or close to, zero so share buybacks only begin in 2025. This could be one outcome of the crisis: airlines lowering target leverage ratios. (Southwest entered the Covid-19 crisis with slightly negative net debt.) Of course, another possible outcome is Air Canada keeps its leverage ratio target at 1.0, and share buybacks begin in 2024. In either case, as soon as an investment grade rating is awarded, the Airline would likely repay government loans and remove buyback restrictions.
2024 2025 2026 Revenue ($billions) 19.90 20.90 21.90
Ebitda ($billions) 4.57 4.80 5.04
Cash Flow – Operations 4.84 5.10 5.34
Capex ($billion) 1.40 1.40 1.40
Free Cash Flow ($billion) 3.44 3.70 3.94
P/FCF Multiple 12x 12x 12x
Market Cap ($ billions) 44.4 47.3 ---
Share Float (millions) 370 347 ---
Share Price (end-year)
Based on next year’s FCF $120 $136 ---
Average price of share buyback in 2025: $127 (FCF – $500 million, or $2.94 billion is used to repurchase shares)
Applying the average trailing 12-month multiple achieved in late 2019 by the two airline groups mentioned above (13.9 times for the four global airlines and 13.5 times for Delta and United) to the estimated free cash flow in 2024, then the 2025 year-end share price should be $135 (13.7 x $3.44 billion/347 million)
2025 Market Cap ($ billions) 47.1
Share Float (millions) 347
Share Price $135
The Rug Seller, once again….
A man, having looted a city, tried to sell one of his spoils, an exquisite rug. “Who will give me 100 gold pieces for this rug? he cried throughout the town. After the sale was completed, a comrade approached the seller, and asked, “Why did you not ask more for that precious rug?”
“Is there any number higher than 100?” asked the seller.
Using the EV/IC valuation model and the 2014 Credit Suisse linear regression result, the end-2025 share price, based on estimated invested capital, despite the most recent share dilution, should be in the $100 range. Using the Price to Free Cash Flow valuation, Air Canada should easily earn a multiple, at the very least, similar to the ones the other noted airlines were enjoying by 2019, pushing the share price higher.
Importantly, as Air Canada increases ROIC – the key value driver – toward the 23 percent range and achieves a capital efficiency ratio above three, even higher EV/IC, P/FCF and P/E multiples should be achieved – similar to Southwest’s performance – particularly since a greater portion of earnings, cash flows and free cash flows will be generated by higher margin business units (loyalty and cargo) independent of the airline economy, businesses typically assigned higher multiples anyway.
The essence of Air Canada’s future share price performance comes down to this one, simple algorithm: The application of a high capital efficiency ratio to a substantial capital base.
Longer-term investors who believe we’re in a 15 to 20 year secular bull market, and at the beginning of a new business cycle, should consider Air Canada as an investment providing it fits within their risk profile.
You don’t see anything until you have the right metaphor to perceive it.
– Robert Shaw, the Physicist