Onex and WestJet:
Local and global fall-out May 2019

In May Onex, a private equity fund, made a successful bid for WestJet, offering C$3.5bn (US$2.6bn), or C$31 per share, roughly 67% above the C$2.1bn that the Toronto stockmarket had been valuing the airline at for the past year. This is a development that will not only shake up the Canadian market but could have wider repercussions for international competition.

The transaction will not be completed until the end of this year, and needs to go through regulatory assessment, but it is difficult to see how any substantial objection could be made, given the Onex’s all-cash price and WestJet management’s fulsome welcome. Clive Beddoe, WestJet’s founder and chairman commented: “I am particularly pleased that WestJet will remain headquartered in Calgary and will continue to build on the success that our 14,000 WestJetters have created. Onex’s aerospace experience, history of positive employee relations and long-term orientation makes it an ideal partner.”

Why was Onex willing to pay such a premium for WestJet? The price of C$3.5bn represents an historic p/e ratio of 38, which means that Onex is anticipating a radical turnaround in profitability under its ownership, and that there is a firm base for this turnaround, which is supported by the fact that the price is just 50% above the airline’s book value. (The deal has also been attributed a total value of C$5bn which includes the WestJet debt assumed by Onex.) To achieve such a turnaround, Onex will have to accelerate WestJet’s current strategy.

WestJet has been going through a fundamental transition (see Aviation Strategy, September 2018), moving from a pure LCC operating mainly 737NGs to a full-service network carrier, expanding internationally with 787s and 737MAXs, increasing its connecting operations, upgrading its premium classes and spinning off a ULCC subsidiary, Swoop.

However, the transition process has eroded WestJet’s profitability. The airline’s 2018 financial results showed an increase in total revenue of 4.9% to C$4.73bn, but operating profit slumped from C$432m to C$155m, while the net result, C$92m, represented a mere 1.9% margin. This is a very poor result in comparison to both leading LCCs and network carriers globally.

WestJet seems to have lost its commercial élan in the Canadian market. Until relatively recently, WestJet was seen as the dynamic upstart from Calgary, and WestJet executives had an almost evangelical belief in their company, while Air Canada was embedded in the Toronto-Ottawa-Montréal triangle, painfully emerging from bankruptcy, trying to shake off its state-supported legacy, and trying to absorb its former rival Canadian.

But the unit cost gap between WestJet and Air Canada has almost disappeared, as WestJet added costs by adding complexity while Air Canada partly re-invented itself through the “global champion” strategy implemented by CEO Calin Rovinescu. In 2018 Air Canada produced C$677m in net profits, 3.8% margin — significantly underperforming US and European network carriers but appreciably better than WestJet (Aviation Strategy, March 2019).

The Onex purchase removes WestJet from the tyranny of quarterly reporting and responding to the shorter term concerns of the stockmarket over, notably, the grounding of WestJet’s fleet of 13 737MAXs, 10% of its system capacity. On the other hand, the view that Onex’s takeover will allow smooth implementation of a long-term plan, supported by Onex’s deep pockets, is a little benign.

Private equity companies make their profits from exiting — selling or refloating purchased companies, having turned their operations around, usually through cost cutting. Onex’s targeted return on investment is 20% pa over a 5-8 year period. To to achieve this it is likely that Onex will load up WestJet with debt, which immediately defrays its own cost of acquisition, and leverages the return on equity, if the company improves its financial performance (the opposite effect if the financial situation deteriorates).

WestJet’s balance sheet is already quite highly leveraged; at the end of 2018 it had C$4.6bn of total liabilities, including C$1.44bn in long term debt, against C$2.3bn of shareholders equity, a ratio of 2/1. Standard & Poor’s, has responded to the Onex purchase by putting WestJet’s debt rating, currently BBB-, on credit watch.

The Onex deal has been driven by Gerry Schwartz, CEO of the $31bn fund. Back in 1999 he launched a bid for Air Canada, with the intention of merging the flag-carrier with Canadian, and creating a globally-competitive airline. That bid looked very likely to succeed until Air Canada brought in a lawyer — Calin Rovinescu — who at almost the last minute blocked the takeover on technical grounds.

So there is a bit of personal history, and that adds to the competitive threat faced by Air Canada from a resurgent WestJet. There is no doubt that WestJet under Onex will be expansionist within the framework of alliance; the question is what type of expansion.

One approach would be for the new WestJet to invade more of Air Canada’s markets in the east of the country with the ultimate aim of a takeover or merger, the logic being that Canada’s air transport market — 90m domestic passengers, 29m cross-border and 33m other international — cannot support two global network carriers (Air Canada/ Canadian replayed), especially with the emergence of a new wave of ULCC types, Flair Airlines and others.

The other, more likely, approach, would be to expand and compete within the context of global alliances. WestJet currently is not a member of a global alliance, though it has in the past flirted with oneworld, but that could change as its relationship with Delta, and in the future SkyTeam, develops.

In November last year WestJet and Delta applied to the US DoT for antitrust immunity for their cross-border joint venture. This will allow the two carriers to fully coordinate services, jointly set fares and share profits on routes between 30 Canadian and US cities. Although Air Canada continues to be the major player on cross-border routes, it does not yet have an immunised agreement with its Star partner United.

One can envisage an extension of the immunised agreement to the Atlantic with WestJet becoming part of the SkyTeam JV as a junior partner to Delta and Air France. Conceivably, it could develop a similar role within the alliance to that of Aer Lingus within oneworld — lower cost than the Legacies, concentrating on leisure traffic but also offering a good business product.

Across the Pacific, WestJet at a later point could slot into the immunised SkyTeam JV with Delta and Korean Air. WestJet’s strong market position on the Canadian west coast, which has such strong social and economic links to China, is a key asset.

Speculating with regard to Onex’s exit strategy, might Delta be a candidate for investing in WestJet, as it has previously done with Virgin Atlantic and Aeroméxico? The Canada Transportation Act 2018 increased the percentage of foreign ownership allowed in Canadian airlines from 25% to 49%.

Back to the present, Air Canada has responded to Onex by moving for the Montréal-based tour operator Transat, parent of Air Transat, offering C$540m for the C$3bn turnover company which just about broke even in 2018. But Air Transit is a substantial player on Canadian long-haul routes — its own figures indicate that a merger would increase Air Canada’s market share on Canada-Europe routes from 43% to 63%.

What does all this imply for the LHLCC sector on the Atlantic?

Despite its global network ambitions, WestJet has continued to promote its low cost credentials on Canada to the UK and France routes, and it was a founder member along with Norwegian of Worldwide by easyJet, the low cost short/long-haul connecting operation based at Gatwick. If the carrier moves down the global alliance route, its competitive strategy will be tempered by Delta and Air France.

The traditional LHLCCs — the carriers from an inclusive tour background which operate long-haul as well as short-haul — are disappearing or being recaptured by Legacy carriers. Monarch has gone. Air Transat will probably become an Air Canada subsidiary. Thomas Cook is dismantling itself in an attempt to survive, with the Condor brand probably being re-taken by Lufthansa while Virgin Atlantic is reported to be thinking of Thomas Cook Airlines.

The table reveals how significant these long-haul charter/scheduled carriers are, or have been, in certain long-haul markets:

• Air Transat from Canada to all European cities, particularly secondary ones like Manchester and Glasgow, in direct competition with Air Canada.
• Condor dominant from Frankfurt to mostly Caribbean leisure destinations but also in direct competition with Lufthansa on four important city pairs.
• Thomas Cook Airlines, very important out of Manchester in particular, to US and Mexican leisure cities, competing directly against Virgin Atlantic and TUI.

With WOW and Primera bankrupted, financially stressed but resilient Norwegian is the only independent LHLCC left. Inevitably, there are rumours of new bids either from a Legacy carrier (but not IAG again) or an equity fund. No short-haul LCC is interested at this point.