|
|
|
|
||
Air Canada Remains in Stasis, But Canada Is Reopening Its Borders in the Third Quarter Air Canada Remains in Stasis, But Canada Is Reopening Its Borders in the Third Quarter Burkett Huey Equity Analyst Analyst Note | by Burkett Huey Updated Jul 23, 2021 No-moat rated Air Canada reported another difficult quarter due to low levels of travel, but we are maintaining our CAD 28 fair value estimate. Canada continues to be more restrictive in its domestic and international travels than its southern neighbor, but the country announced it would soon ease restrictions considerably. Passenger revenue increased 28.1% sequentially as available seat miles decreased 5.0%, load factors dropped 3% to 42.2%, but yields increased 39.0%. Passenger revenue remains at about 9.8% of 2019 levels as Air Canada’s business model remains fundamentally tethered to international travel. Although this was not reflected in operating results, forward booking increased significantly with the easing of travel restrictions for travel within Canada, and Canada reported that it will start accepting fully vaccinated individuals from the U.S. starting Aug. 9 (first time in nearly 16 months). We view this as a fundamental turning point for the firm, as it can transition from conserving cash to redeploying capacity in a growing market. Further, the firm expects that business travel will begin recovering around Labor Day, so the delay between U.S. domestic leisure travel’s recovery and Canada’s would not be replicated for the return of business travel. The firm burned about CAD 745 million during the quarter and raised USD $5.35 billion in refinancing, USD $3.7 billion of which will be used to refinance its current 2023 and 2024 loans. The firm had around CAD 9.8 billion in unrestricted liquidity at the quarter's end. Assuming the firm has a minimum cash requirement of about CAD 500 million, we estimate that the firm could continue burning cash at this rate for about 12.5 quarters without running into a liquidity crisis. Since Canada will open its borders this quarter, which we think will materially reduce cash burn, we think this is probably a tail-end risk. The firm posted a net loss of CAD 3.31 per share this quarter. Business Strategy and Outlook | by Burkett Huey Updated Feb 14, 2021 Air Canada is an internationally focused airline. Only about 22% of 2019 capacity was utilized for domestic Canadian flights and less than 20% of capacity was for U.S. transborder flights. Air Canada’s strategy before the coronavirus pandemic was to capitalize on so-called sixth freedom traffic, which is flying (mostly) U.S. nationals on long-haul international routes with a layover in a Canadian airport. In our view, Air Canada came into the COVID-19 crisis in better financial shape than many U.S.-based peers, but its internationally focused business model will face considerably more stress than domestically focused U.S. peers. We’re anticipating a short-haul leisure-led recovery, and we think that Air Canada’s low-cost carrier, Rouge, will continue providing a low-cost product that effectively competes against entrants like Enerjet. That said, since Rouge shares some costs with the mainline, we think that it will be difficult for Air Canada to profitably deliver the lowest price. We expect that long-haul leisure traffic is unlikely to return until a COVID-19 vaccine is distributed globally. We don’t expect that Air Canada will give up on its strategy of providing long-haul leisure routes and anticipate that the firm will keep capacity lower for longer until international travel demand returns. We expect that Air Canada will participate in the recovery of business travel after a vaccine for COVID-19 becomes available. Air Canada reacquired its frequent flyer program, Aeroplan, in 2019. The popularity of frequent flyer miles as a rewards currency means that banks are willing to pay top dollar for these frequent flyer miles, which provides a high-margin income stream to the airline. It remains uncertain if Air Canada can capitalize on the program to the same extent that U.S.-based peers have. The pandemic has been airlines’ sharpest demand shock in history. Industry participants have cut most of their capacity and the aircraft that are still flying are flying at low load factors. The Canadian government has particularly stringent travel restrictions, so we anticipate that the company will generate large operating losses until a vaccine is well-distributed. Economic Moat | by Burkett Huey Updated Feb 14, 2021 We do not believe that Air Canada has earned a moat, but we think that the company’s planned acquisition of its frequent flyer program will structurally improve its business model. Airlines have traditionally been an industry in which a no-moat rating is almost too generous, with an infamous history of value destruction as measured by subpar returns on capital. IATA, an international industry group, estimates that industrywide returns on invested capital have not breached 8% in the past 15 years. In our view, there are structural factors that make it difficult for airlines to generate excess returns: a mostly undifferentiated product, a tendency for irrational competition, substantial operating leverage, and a tendency to employ financial leverage that exacerbates booms and busts. While Air Canada has structural advantages to its airline business, particularly the consolidation in the Canadian airline market and its newly acquired frequent flyer program, we do not think this is enough to build a moat for two big reasons. First, the firm’s airline operations remain large and capital-intensive enough that we don’t expect substantial excess returns, even in the best of times. Second, airlines remain highly sensitive to unpredictable cyclical turns that can quickly destroy quite a bit of value during difficult times. Airlines have historically sold commodity goods and operated in a highly competitive market, so participants in this market have traditionally been unable to control prices or costs. Typically, the primary moat source for highly competitive companies with commodity products is a cost advantage. Durable cost advantages for industry participants are elusive because low-cost carriers and ultra-low-cost carriers’ business model is predicated on continuously driving down yields to attract customers with lower fares. Although the Canadian market is highly consolidated, new entrants such as Enerjet have announced an intent to enter the market, and there are low-cost carriers within larger airlines such as Westjet’s Swoop carrier to erode any cost advantage. We think that the frequent flyer programs are essentially a capital-light business with the potential for intangible assets and switching costs attached to a capital-intensive, highly competitive airline business. Intangible assets would come from the long-standing and contract-based relationships that airlines have with credit card companies to sell frequent flyer miles. Switching costs would come from being the sole provider of a currency, frequent flyer miles, that credit card holders find valuable. The switching costs would specifically be due to credit card companies facing difficulties in providing their customers with rewards cardholders want. Air Canada reacquired its frequent flyer program, Aeroplan, in 2019. While we believe that these capital-light businesses improve the returns on capital of capital-intensive businesses, we aren’t comfortable giving Air Canada a moat due to the substantial losses airlines face during unfavorable cyclical turns. At this time, we do not have enough certainty that the core airline business has escaped its long-running tendency to destroy value in normal times and we do not have enough certainty in the sustainability of returns from the capital-light frequent flier program to grant any airline a moat. Fundamentally, the business of frequent flyer programs can be simplified to airlines selling miles to banks. Airlines recognize revenue from selling miles to credit card companies on the frequent flyer programs in four ways. First, through marketing revenue, which represents the difference between the selling price of the mile and the redeemable value of the mile. We view this revenue as almost entirely incremental to the airlines and assume that a 90% margin on this revenue is reasonable, as airlines assume modest performance obligations such as email campaigns, in-flight advertising and airport advertising. Second, there are nontravel awards (which generally account for only a fraction of awards redeemed) such as baggage, priority boarding, and lounge access, which we assume a 70% margin on. Third, there are travel-related awards, which we conservatively assume have a similar margin to the rest of the passenger revenue, although we have reason to believe that a material proportion of these awards are used to upgrade existing travel, which would be a higher-margin transaction than new travel. Finally, there is breakage revenue from miles that do not get redeemed. We estimate that the loyalty programs have operating margins of 35%-45% and constitute a significant proportion of operating income for the airlines. In terms of the sustainability of these businesses, the driving forces behind mileage sales are new card openings and spending on cards. While Morningstar anticipates continued growth in credit card spending and anticipates that fees to merchants as a proportion of credit card spending will remain reasonably constant, benefits from new card openings are not sustainable over the long term. We view this as a solid business going forward, and while we aren’t anticipating 2015 margins to return any day soon, we think that the frequent flyer program will continue to be a major driver of operating income. The coronavirus crisis has presented the industry with its sternest test in history. Peak year to trough year capacity declines of midsingle digits after 9/11 and the financial crisis pale in comparison to the nearly 50% industrywide capacity declines we’re projecting in 2020. Previous recessions invited consolidation, allowing remaining firms to continue growing, but we do not anticipate further consolidation to be possible. While we think that COVID-19 pandemic will not change the structural improvements to the U.S. airlines, we do think this cyclical shock highlights the lack of a moat in this industry. Fair Value and Profit Drivers | by Burkett Huey Updated Jul 23, 2021 After second-quarter earnings, we're maintaining our CAD 28 fair value estimate. Our fair value is driven primarily by the severity of operating losses in 2021, the pace of the recovery in air traffic, and our midcycle profitability assumption. Airlines faced the worst operating environment in history in 2020 due to the COVID-19 pandemic and dramatically cut capacity to respond to steep drops in demand. The worst is not quite over yet for Air Canada, as travel restrictions in Canada are just starting to be lifted, but we see a leisure-led recovery for airlines and anticipate Air Canada can return to 2019 levels of capacity in 2024, slower than U.S.-based peers. Canada has recently announced it intends to open the border to U.S. citizens in the third quarter, which is a good start for Air Canada's recovery. Air Canada will recover in earnest when it can resume its business model of acting as a fifth freedom carrier that accesses global travel market. We expect Air Canada's fundamentals will recover with reduced border restrictions, which we expect will start in 2021 and accelerate in 2022. We expect 2021 will be partially a continuation of 2020's operating environment and partially a recovery. We anticipate 2021 capacity will be about 30% of 2019 levels and that capacity will grow dramatically in 2022 as international travel restrictions ease. Our 2025 capacity is roughly 6.5% higher than 2019 levels. We expect 2021 load factors will be roughly 63% and that yields will decrease in 2021 due to slightly higher levels of low-yielding international travel in the mix. Our midcycle operating margin for Air Canada is about 10.4%, 130 basis points above the 2015-19 average. We think that the company can return to 2019 capacity levels with lower staffing levels and we think Air Canada’s acquisition of its frequent flyer program will be margin accretive. We’re expecting capital expenditures will be about CAD 1.0 billion in 2021, as the firm seeks delivery relief from aircraft manufacturers, and we expect capital expenditure will average about CAD 1.8 billion per year over our forecast period. We think an above-average cost of equity and debt are reasonable for this airline, which leads us to a WACC of 8.4%. Risk and Uncertainty | by Burkett Huey Updated Feb 14, 2021 Airlines are exposed to the geopolitical risks on each node on its network, face commodity price risk from the oil market, risk of irrational competition, and general cyclical risk. The geopolitical risk is broad, as any number of unpredictable events such as wars, pandemics, international tension, and natural disasters affect travel. Fuel is airlines' second-largest cost, and we expect it to be a major variable cost for airlines for the foreseeable future. Air Canada does not hedge fuel costs and would likely face substantial margin pressures in the event of an oil price spike. Airlines have a long history of irrational competition, due to low entry barriers, high exit barriers, and a price-sensitive customer. Low-cost carriers and ultra-low-cost carriers have tendencies to enter markets and drive returns down for all participants due to an excess of supply for a somewhat fixed pool of demand. We think that the consolidated Canadian airline market reduces, but does not eliminate the potential for irrational competition, as there are fewer competitors to act irrationally. Air travel is generally a discretionary good that closely tracks GDP. Recessionary economic contractions reduce travel demand, which is an ongoing risk to airline investors. We see some environmental, social, and governance risk for Air Canada, largely the result of greenhouse gas emissions from the company's operations. If carbon taxes are enacted, airlines would likely pass the cost onto the consumer, which we anticipate would reduce aggregate travel demand. At this point, ESG risk does not affect our fair value or our scenario analysis. Capital Allocation | by Burkett Huey Updated May 07, 2021 We assess the stewardship of Air Canada to be Standard. This assessment was conducted using our prior stewardship methodology. We will be transitioning our assessment mechanism for Air Canada, and the balance of our stock coverage, to the Capital Allocation methodology by the end of September 2021. Former CEO Calin Rovinescu turned the airline around from near bankruptcy in the financial crisis to a solid carrier that has found a way to escape the ultimately limited Canadian market. We think that Air Canada’s strategy of operating long-haul flights for U.S. nationals to international destinations is reasonable, if not unique, as other airlines such as the Gulf carriers operate similar business models. While international and long-haul flights are in particular distress from the COVID-19 pandemic, and we expect Air Canada to rebound more slowly than domestic peers, we cannot fault management for this, as we think the pandemic was largely unforeseeable. Rovinescu retired in February 2020, and the former CFO, Michael Rousseau, has assumed the role. This executive shift does not affect our long-term view of the company. We also commend management for navigating labor disputes, pension difficulties, and fuel price challenges, and deleveraging the company. Air Canada came into the coronavirus crisis with a much better balance sheet than it had previously and quite a bit of cash on hand, which gives it a bit more flexibility relative to peers. In no-moat industries like airlines, we think that stewardship matters quite a bit in determining the overall quality of a firm, and we think that Air Canada’s management has cleverly found ways to create value in a limited market. We think the fact that the firm was the top-performing stock in the Toronto Stock Exchange from 2009-19 is indicative of the substantial value created by the firm, though we recognize that part of this is due to bankruptcy fears at the beginning of the period. |
return to message board, top of board |