Air Canada: Target is to eliminate
gap with US peers March 2019

Air Canada held a bullish investor day on February 28 that included much talk about network diversification, sixth freedom traffic, low-cost unit Rouge, fleet renewal, balance sheet strengthening and other successful strategies pursued in recent years.

Senior executives announced lofty financial targets for the next three years and promised substantially lower capital spending and more aggressive share buybacks. They argued that continued deleveraging would make the business more resistant to economic downturns and, hopefully, result in investment-grade credit ratings.

Under the new plan, Air Canada targets an annual EBITDA margin of 19-22% and annual ROIC of 16-20% in 2019-2021. Aggregate FCF in the period would be C$4-4.5bn, including C$400-600m in 2019. The leverage ratio (net debt/EBITDAR) would be reduced from last year’s 2.1x to 1.2x at the end of 2019.

Unfortunately, just two weeks later, Air Canada had to suspend the financial targets for 2019 in the wake of the Boeing 737 Max’s worldwide grounding.

Air Canada is feeling much impact as it operated 24 Max 8s on March 13, accounting for 6.6% of its ASMs, and had expected to receive another six in March and April. Its narrowbody fleet transition relies heavily on the Max: there are 43 firm orders for delivery in 2019-2024.

The immediate operational impact has been manageable. Air Canada has backfilled nearly all of the grounded capacity through delaying aircraft retirements, extending leases and enlisting the help of Rouge and international partners. But it has had to temporarily suspend transatlantic services linking Halifax and St. John’s with London Heathrow (passengers are rerouted through the Toronto and Montréal hubs).

The negative effects will worsen if the Max grounding extends into the peak travel season. Air Canada has acted more conservatively than its peers by removing the Max from its schedule until July. However, if the Max issues are resolved this year, Air Canada could get back on track to achieve the investor day projections from next year onwards. For now the airline is sticking to the 2020 and 2021 targets.

Air Canada has come a long way since 2009, when it almost ran out of cash and faced extinction after years of high costs and financial losses (despite many bailouts and restructurings). It managed to pull itself out of that crisis thanks to labour and supplier concessions and some creative financings.

The subsequent transformation has been nothing short of miraculous. Air Canada staged a strong financial turnaround in the first half of this decade, enabling it to achieve 10%-level annual operating margins for the first time in 2015 and 2016.

There was also a dramatic shift in labour relations. For reasons that are not entirely clear, Air Canada managed to transform itself from an airline with horrendously bad labour relations to one with a happy workforce and an “entrepreneurial, can-do culture”. In 2015 it even secured 10-year agreements with its key unions.

By most standards, Air Canada has delivered on the “global champion” strategy introduced in 2010 by Calin Rovinescu soon after he became CEO. Rovinescu’s strategy had four core components: cost cuts and revenue initiatives; pursuing profitable international growth opportunities; enhancing product/service differentials; and fostering cultural change.

In the past five years, Air Canada’s operating revenues have surged from C$12.4bn to C$18.1bn (US$ 13.4bn) in 2018 — a CAGR of 7.8%. In the same period its annual passenger numbers rose by 42% to 50.9m last year.

Progress with costs has been particularly swift since 2012 when more initiatives were adopted — boosting aircraft utilisation, ordering more efficient aircraft, launching Rouge and revising the contract with regional carrier Jazz. Since 2012 Air Canada has reduced its ex-fuel CASM by 9.8%, compared to an 8.9% increase seen by WestJet and a 16.9% increase for the average of the three largest US carriers (figures from Air Canada’s recent presentation).

Air Canada claims that its ex-fuel CASM has fallen by 14% since 2012 if “normalised for the impact of the US$/C$ exchange rate on operating expenses” and that on that basis its unit costs are now similar to those of the largest US network carriers.

The cost differential with the main Canadian competitor, WestJet, is also diminishing, although that largely reflects WestJet’s changing business model. Air Canada calculates that its 2018 ex-fuel CASM was only 4.6% higher than WestJet’s.

In the past five years Air Canada has been on a major international expansion drive, having identified an opportunity to tap sixth freedom traffic. It has also continued to grow Rouge after its pilots relaxed their original 50-aircraft maximum limit for the unit.

The balance sheet has strengthened significantly. For example, adjusted net debt/EBITDAR has fallen from 8.3x in 2009 to the 2.1x-level in the past two years. And Air Canada now has a pension plan surplus of C$2.4bn, compared to a surplus of C$1.3bn in 2015 and a deficit of C$2.7bn in 2009.

Air Canada’s share price has more than quadrupled in the past three years; yet, most analysts see room for further improvement and continue to recommend the stock as a buy or strong buy.

The negative is that Air Canada’s profit margins continue to lag those of the US network carriers, and the company continues to be undervalued relative to its US peers. Its operating margin peaked at 10.8% in 2015, and since then has somewhat declined (9.2% in 2016, 8.4% in 2017 and 6.5% in 2018).

Air Canada’s aim is to eliminate the gaps with its US rivals, and strategies disclosed at the investor day may help accomplish those goals.

Tapping sixth freedom traffic

Targetting sixth freedom traffic between the US and the rest of the world has been the cornerstone of Air Canada’s growth strategy in the past five years. The strategy takes advantage of the carrier’s many inherent advantages: Canada’s geographical position, with proximity to the world’s largest air travel market; the US-Canada open skies ASA; Air Canada’s well-positioned hubs (Montreal, Toronto and Vancouver); and Air Canada’s extensive traffic rights.

In many cases, Air Canada can offer the shortest route to and from the US. The strategy has been successful also because of the efficient transfer processes offered by the airports; not having to pick up bags is crucial for attracting international transit traffic. Another selling point has been Air Canada’s superior product (compared to US airlines).

Air Canada’s international transit traffic grew by 15% in 2018 (versus 2017) and has increased by 142% since 2013. Still, last year the carrier’s share of long-haul international traffic to/from the US (US-Pacific and US-Atlantic) was still only 1.3%; the management made the point that increasing that share to 2% would translate into around C$675m incremental annual revenue.

The sixth freedom strategy has enabled Air Canada to expand its international network far beyond what Canada, with a population of 37m, could support. Since 2009 the airline has added 64 new destinations, of which 48 have been international.

US transborder and long-haul international operations now account for 71% Air Canada’s passenger revenues, up from 62% in 2012. Such diversification away from the domestic market is critical as increased competition from ULCCs will very probably drive down domestic fares.

In recent years the fastest growth has been on the transatlantic, where in 2018 alone Air Canada and Rouge added 18 new routes. Management sees an opportunity to increase “highly profitable hub-to-hub flying” within the Atlantic JV, to better link the Canadian hubs with Brussels, Frankfurt, Munich, Vienna, Zürich and Geneva.

Airline partnerships feature prominently in Air Canada’s global strategy. In addition to further strengthening what it calls its “A++” Atlantic JV with United, Lufthansa and others, Air Canada will be developing the Pacific JV it signed with Air China last year.

The future will also see Air Canada launch more counter-seasonal routes, deploy Rouge to up-gauge more regional flights and leverage the Max and the A220 in North America.

The first of Air Canada’s 45 A220-300s is scheduled to enter service in January 2020. The executives noted that the type’s “unparalleled operating economics” will open many new possibilities, including routes such as Vancouver-Washington DC and Montreal-Seattle.

Plans for the 737 Max see it deployed just about everywhere: to Europe, Hawaii, transcon, Mexico and the Caribbean.

The benefits of Rouge

Air Canada’s international growth has also focused on competing more effectively in the leisure market to and from Canada with the help of Rouge. The “airline-within-an-airline” concept faced much scepticism initially but has been successful. Since it first flew in July 2013, Rouge has carried 30m passengers, grown its fleet to 53 aircraft and expanded its network to 70 destinations on five continents. Its stage-length adjusted CASM is 29% lower than Air Canada’s.

Management described Rouge as a “key strategic tool” that enables Air Canada to compete in leisure markets, swing capacity from the sun markets in the winter to the transatlantic in the summer, and effectively defend against ULCCs in Canada.

Particularly important is the coordinated approach that leverages the strengths of the mainline operation, Rouge, Air Canada Vacations and Air Canada Express. Notably, Rouge has helped facilitate strong growth for Air Canada Vacations, also helping it to offer domestic holiday packages.

Rouge’s CASM and margins will benefit further from the growth of its current predominantly-A319 narrowbody fleet to include the larger A320s and A321s. The A320s are coming from the mainline fleet (see table). Rouge also operates 25 767-300ERs.

Fleet plans and capital allocation

Air Canada is nearing the end of its widebody fleet renewal programme, which has seen it build a 35-strong 787 fleet and steadily retire 767-300ERs. The last two 787s on firm order will arrive this year. There will also be four A330 deliveries in 2019, which will facilitate the retirement of the six remaining 767s in the mainline fleet, and one more A330 delivery in 2020.

The only other widebody spending anticipated at this point is the need to replace some of Rouge’s 767-300ERs by the mid-2020s.

The focus has now shifted to the narrowbody fleet transition. The 43 737 Maxes on firm order (with deliveries currently suspended) are intended to replace the mainline A320-family fleet, resulting in an estimated 11% CASM saving.

Air Canada has 45 A220-300s on firm order for delivery to the end of 2022. The type offers a 12% CASM advantage over the E190, which it will replace (among other uses).

With the widebody renewal winding down, at the investor day Air Canada forecast its total annual capital expenditure to decline from C$2.9bn in 2019 to C$1.4bn in 2021. Non-aircraft capex (mostly investments in technology) would amount to around C$600-800m annually, meaning that fleet capex would fall from C$2.2bn in 2019 to only C$700m in 2021.

Some of those projections may well change as a result of the Max crisis, but one thing seems certain: Air Canada will have much more free cash flow at its disposal.

The plan is to continue to deleverage, buy most of this year’s aircraft deliveries with cash and return more capital to shareholders.

In the first place, Air Canada intends to repurchase stock more aggressively when opportunities present, but dividends would also be considered.

Air Canada’s balance sheet is in reasonable shape, with unrestricted liquidity of C$5.73bn (32% of annual revenues), shareholders’ equity of C$4.0bn and adjusted net debt of C$5.86bn at the end of 2018. The airline expects to maintain a pension plan surplus in the next three years.

One of the themes at the investor day was that Air Canada is keen to obtain investment-grade credit ratings and that the management believes that the targeted 2019 leverage ratio of “no more than 1.2x” would support that.

Air Canada is certainly heading in the right direction: its credit ratings with S&P and Moody’s have improved steadily since 2012. But the ratings are still two notches below investment grade, so analysts have suggested that getting there could take a year.

Closing the valuation gap?

Air Canada’s earnings growth prospects are promising. Its growth rate is moderating. It can start consolidating the impressive global network it has built. There are good opportunities to grow ancillary revenues, expand Rouge and continue to build the cargo and vacations businesses. C$250m of new cost savings have been identified for 2019. An improved and expanded deal is in place with regional partner Jazz.

There are also two major value-enhancing initiatives in the pipeline. First, Air Canada plans to implement a new reservation system in late 2019 that is expected to generate C$100m-plus in annual benefits. Second, mid-2020 will see the implementation of a new loyalty programme that has an NPV in excess of C$2.5bn.

But why would Air Canada launch a new loyalty programme after spending C$450m to buy its former loyalty business Aeroplan back from Aimia (a transaction that closed in January)? Apparently because having Aeroplan’s expert team, customer data and partner relationships will “significantly accelerate and de-risk” the launch of the new programme.

One of the big themes at the investor day was that Air Canada has lowered its risk profile and become more resistant to economic downturns. It has a lower financial leverage, record liquidity levels, a US$2.6bn pool of unencumbered assets and flexibility in its fleet plan (via lease expirations and apparently “deferral rights on new aircraft yet to be delivered”). There are currently 55 unencumbered aircraft in the combined Air Canada/Rouge fleet, a figure that is projected to rise to 100 by 2021 (40% of the fleet).

The executives argued that Air Canada has “demonstrated that it can be sustainably profitable over the long-term”. They have modelled a recession scenario similar to the 2008/2009 recession against its three-year business plan and concluded that the EBITDAR margin contraction would be “less than half of the 500 basis point decrease we experienced in 2009 for the year following the start of the recession”. However, they also recognise that Air Canada may have to actually go through an economic downturn to convince all investors.

They believe that the earlier higher cost of regional lift and not having an in-house loyalty programme — both outcomes of the ACE restructuring 15 years ago — were the “two key inhibitors to reaching or exceeding the valuation multiples enjoyed by US airlines”. Both of those issues have now been dealt with.