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Air Canada (AIDIF.PK) could be forced to file for bankruptcy protection if it does not obtain additional financing through asset sales and renegotiate its credit card agreement covenants, according to UBS analyst Fadi Chamoun.

The airline filed for bankruptcy protection in 2003 and emerged 18 months later after restructuring with new deals with creditors, unions and bankers.

Notwithstanding lower fuel costs, Mr. Chamoun believes that Air Canada’s cash from operations will be insufficient to meet rising pension funding obligations and more than C$1-billion of debt repayment in the next two years, including C$660-million in 2009. He told clients that the covenants in its credit card agreements could tighten further in the second quarter, forcing the company to maintain higher cash deposits.

The analyst said little value can be assigned to Air Canada equity due to its worsening revenue trends and roughly C$7.5-billion debt position, which excludes a pension solvency deficit of C$3.2-billion.

As a result, he downgraded his rating on the stock to “sell” from “neutral” and cut his price target to C$1 per share from C$1.50. Mr. Chamoun added that Air Canada’s EBITDAR needs to double before he can find any value for the equity.

Versant Partners analyst Cameron Doerksen also cut Air Canada to a “sell” after the airline’s fourth quarter results came in below forecasts and the falling Canadian dollar led to a C$527-million writedown. He is no longer providing a target price for Air Canada shares.

Along with the return of its liquidity troubles, the company also faces pension and labour challenges to go along with difficult economic conditions, the analyst said in a research note.

Mr. Doerksen said:

Air Canada indicates that it has unencumbered assets of about C$1.0B, but given the state of credit markets and a deteriorating aircraft financing market, the ability to generate cash from these assets is questionable.

He also noted that all of Air Canada’s major union agreements are up for renewal by mid-2009. Meanwhile, its pension deficit, which skyrocketed from C$1.2-billion from a year ago due the to steep decline in financial markets, may result in C$410-million of additional cash funding obligation relative to 2008.

However, while he does think Air Canada will remain a going concern, the analyst sees no compelling reason to own the stock right now.

RBC Capital Markets analyst Nick Morton said less than 5% of Air Canada’s enterprise value is its equity. He changed his rating from “above average risk” to “speculative risk” in order to reflect rising debt levels, pressure on fares and risks surrounding union contracts expiring in June. The analyst also cut his price target from C$8 per share to C$4.

While he said pension funding could become a serious challenge in 2010 if a funding compromise cannot be reached, Mr. Morton said the decline in crude and the closing of some fuel hedges has allowed Air Canada to reduce the amount of collateral it must post.

Calling this pension deficit “insurmountable,” Raymond James analyst Ben Cherniavsky expects solvency payments will increase by approximately C$160-million – assuming the Federal Government provides some relief. Current fuel prices are also expected to provide some breathing room for Air Canada in the coming quarters and should help it surmount a major liquidity crisis, the analyst told clients.

Mr. Cherniavsky said:

However, we do not believe this is sufficient enough to off-set other big risks that still loom, including a global recession, ballooning pension obligations, a precarious labour situation, significant debt levels, and a projected 7% rise in non-fuel CASM [operating expense per available seat mile].

His price target on the stock is under review.

CIBC World Markets analyst Chris Murray noted that Air Canada is seeking permanent changes to how its defined benefit pension plans and solvency deficits are calculated. The choice of discount rate has a major impact on the deficit as a switch to a higher AA corporate bond rate, which is permitted in the U.S. and elsewhere, could result in Air Canada’s pension plan being in a surplus position, Mr. Murray told clients. This would require no additional funding.

He said:

While there are a number of significant issues facing Air Canada, we believe the company’s actions in reducing capacity and removing additional downside related to its fuel hedging losses should allow a return to higher earnings and cash flows in 2009 and beyond.

Mr. Murray cut his price target from C$10 per share to C$7.50.

Source: Air Canada Might Face Bankruptcy Protection