WestJet and Air Canada: Fuel Charges Are Good for Earnings, Bad for Load Factors

At first glance, new fuel surcharges from WestJet Airlines Ltd. (WJAVF.PK) and Air Canada (AIDIF.PK) mean a positive impact on earnings. However, what many of the financial calculations do not include is the potential decrease in demand from these significant price increases.

“Air travel has always been a famously cyclical and price‐sensitive discretionary item,” said Ben Cherniavsky of Raymond James. And, since he has no reason to believe it will be any different this time around, he is telling clients to expect some demand destruction for Canada’s largest airlines.

However, the analyst admits it is difficult to gauge how big the impact will be since surcharges of this magnitude are unprecedented. He is assuming WestJet’s load factor, or the percentage of occupied seats, falls to 80.5% from a previous estimate of 81.7% in 2008. For 2009, he anticipates it will fall to 77.7% from previous expectations of 81.7%.

But these are still high on a historical basis. Couple that with a resilient Canadian economy, as well as the airline’s recent market share gains and an anticipated code-sharing agreement with other airlines, and Mr. Cherniavsky sees plenty of support for WestJet’s load factors for the next 18 months.

He rates the stock an “outperform” with a C$19 price target, saying the market appears to be discounting a lot of bad news into the share price. However, the analyst also noted that WestJet’s fare strategy going forward remains unknown, as does the trajectory of oil prices.

“We remain agnostic about the future price of this enormous imponderable...” he said.

Mr. Cherniavsky rates Air Canada a “market perform” with a C$8 price target, noting that it operates with a higher cost structure than its rival.

Despite the higher earnings forecast for both companies, the analyst expects Air Canada will see a bigger drop in load factors next year. He sees them at 79.5% this year, compared to 80.7% previously, and down to 75.4% from 80.5% in 2009.

Mr. Cherniavsky said:

We believe that Air Canada’s loads are more vulnerable than WestJet’s because of the former’s more premium‐orientated market and its broader exposure to the global economy.

Lower oil prices, an economic recovery or a lower-than-expected surcharge-related impact on loads would definitely help, but WestJet would benefit from these as well.