Seeking Alpha

Ernest Wong's  Instablog

Ernest Wong
Send Message
- B.Comm in Accounting from University of Toronto - Ambitions to run my own hedge fund one day Favourite Books: Fooling some people all of the time- David Einhorn Annual Letters to Shareholders- Warren Buffett Modern Security Analysis- Martin Whitman The Most Important Thing: Uncommon Sense for... More
  • Why Air Canada Is Ready To Soar  2 comments
    Mar 7, 2013 3:59 PM

    **Update: As of March 13, 2013, Air Canada has been granted pension relief from the government up til 2020, which caps special payments at $150 million per year.

    Elevator Pitch

    Air Canada is well known for being a bad investment. It has an enormous pension shortfall, a reputation for poor service and unreliability, and can never seem to be able to get on its feet. However, many recent developments for Air Canada make it a strong buy for the medium/long run going into the future at its current share price. These developments include:

    1) Labour negotiations completed with all major unions in 2012 extending up to 2016 along with a likely extension of the 2009 Air Canada Pension Regulations by the Canadian federal government with support from the unions, basically providing pension relief and labour stability

    2) A new business strategy focusing more on Asia Pacific on increasing margins and decreasing costs (especially those relating to maintenance and labour)

    Company Description

    Air Canada is the largest Canadian passenger and cargo airline in terms of revenues ($12 billion CAD in 2012) and destinations (over 170). Air Canada in its current structure was created as a result of its bankruptcy in 2003, merger with Canadian Airlines in 2001, and privatization in 1998. In addition to its core business, Air Canada also operates the following subsidiaries:

    Air Canada Cargo: Provides shipping services around the world

    Air Canada Vacations: Operates tours and vacation packages around the world

    Air Canada Express: Air Canada's regional flight service (i.e. within Canada, close U.S. destinations). Air Canada Express flights are operated by other companies through purchase capacity agreements with Air Canada.

    Air Canada Rouge: A new low-cost leisure airline launching in 2013 that flies to vacation destinations.

    Air Canada competes with virtually all airlines that fly to Canada for a specific route. For example, it competes Cathay Pacific for the Vancouver-Hong Kong route, and Air France for the Toronto-Paris route. Within North America, its primary competitor is WestJet, and to a lesser extent, Porter Airlines.

    Thesis & Catalyst For ACNB Corp. (AC.B)

    Labour Relations

    Air Canada's dealings with its unions including the IAMAW, CAW, ACPA, and CUPE are vital to the future of the company, especially with regards to pensions for its employees. Wages, salaries and benefits are the 2nd largest operating expenditure (behind fuel) for Air Canada, and pension and other benefit liabilities represents over 1/3 of Air Canada's total liabilities. Shown below are a few key figures relating to Air Canada's pensions:

     

    For Year Ended

    In Millions of CAD$

    31-Dec-12

    31-Dec-11

    Wages, Salaries & Benefits Expense

    $2,109

    $1,991

    As a % of revenues

    17.40%

    17.15%

       

    Pension and other Benefit Liabilities

    $4,689

    $5,563

    As a % of liabilities

    37.81%

    40.79%

    The Pension and other Benefit Liability item on the balance sheet represents an estimate (by actuaries) of the future amount that Air Canada will have to pay to cover the future pension plan shortfall. Under the Pension Benefits Standards Regulations of 1985, companies with solvency deficits (i.e. the amount that the pension plan is short of meeting its obligations if the plan was terminated today) must make special payments to cover the shortfall. In brief, low interest rates and poor performing equity markets especially in 2008 dramatically increased Air Canada's pension deficit, and Air Canada was unable to generate enough cash to make the special payments. To prevent Air Canada from defaulting, the 2009 Air Canada Funding Regulations was passed by the Federal Government with support from the unions (as a default would be in no one's best interest, with the exception perhaps of WestJet). This Act in essence caps the level of special payments to repay pension deficit, which would allow Air Canada much more financial flexibility. The Air Canada Funding Regulations expire at the beginning of 2014, and the Ministry of Finance is currently deciding, with fierce opposition from Westjet, to extend the Air Canada Funding Regulations through 2014. More significantly, the unions support extension of the Funding Regulations.

    This extension is enormously important for the future of Air Canada, its employees, and all its stakeholders, as the company's survival rests on this decision. If the extension is granted (and most indications appear that it will be), then Air Canada will obtain financial freedom for its past pension obligations for 10 years. By then, interest rates should have risen to help cover the shortfall as well.

    Additionally, Air Canada has quietly concluded negotiations with its 5 main unions to amend its defined benefit pension obligations which, subject to regulatory approval, would, by Air Canada's estimate, reduce its solvency deficit by $1.1 billion starting in 2014. As the collective agreements with IAMAW and the ACPA are in place through 2016, this should provide labour stability and prevent losses due to strikes and other labour disruptions.

    Company Strategy

    Since Air Canada will most likely have peace for several years with regards to its pensions and labour relations, Air Canada will be free to execute its strategy, which according to its financial report:

    1)Pursuing revenue enhancements and transforming costs to enhance its competitiveness,

    2)Expanding internationally and increasing connecting traffic through its international gateways,

    3)Engaging with customers, with a particular emphasis on premium class passengers and products;

    4)Fostering positive changes to its culture.

    The fourth goal is not as important (which company doesn't try to foster positive changes to its culture?), so the focus will be on the first three.

    Revenue Enhancement/Cost Transformation

    Air Canada has certainly undertaken much "cost transformation" within the last year, and is planning to do so in the future as well. The translation is basically to find ways to reduce costs, as this will increase profits, and possibly allow Air Canada to lower prices to improve its competitiveness in a very competitive business environment (Air Canada has recently announced a lowest price guarantee).

    The most important cost transformation is the re-negotiation of its pension plans with the unions, which has already been discussed above. There are, however, several other cost reduction initiatives which are discussed in the MD&A. The most important of these are:

    1)New agreements for less expensive aircraft maintenance (This is currently being appealed by Air Canada, as the Quebec Courts have ruled that they are not allowed to switch maintenance contractors away from the province)

    2)Shifting Air Canada's service away from the expensive unionized labour, to cheaper contractors.

    Air Canada is quietly in the process of shifting its flights from its core Air Canada brand to different brand names, such as Air Canada Express. The branding of these is not significant, as consumers will still be flying under Air Canada. In my view, the real reason Air Canada is doing this is to shift flights away from its existing expensive unionized labour to employees with new cheaper contracts, and/or subcontractors who manage their own labour relations. This is hardly a secret, as one of the major logjams in its negotiations with the Air Canada Pilots Association (ACPA) was the right of Air Canada "to get rid of its entire fleet of Embraer planes and "contract out domestic and transborder flying", which has the potential to dramatically reduce labour costs. Of course, the ACPA believes that this would decrease customer satisfaction, but personally, I have faith in Canada's pilot licensing programs, and can't really tell the difference between an Air Canada pilot and a pilot for any other flight operator.

    There are already indications that this is taking place, as Air Canada will transfer 15 of its Embraer 175 airplanes to Sky Regional to operate as a contractor for Northeast USA and Canada routes. Air Canada itself says:

    "Air Canada will derive cost saving benefits from this initiative as Sky Regional's costs to operate these aircraft will be lower"

    The only cost advantages that Sky Regional should have in operating an airplane is labour (both for operating the plane and maintenance), as all other expenses such as fuel, airport fees, and food and beverages should remain constant regardless of the operator of the flight.

    A second area where Air Canada is looking to save costs is through Air Canada Rouge, as its employees for Rouge are mainly new hires, who are compensated under the new cheaper agreements negotiated in 2012. Most of the "new" routes covered by Rouge are already being flown by Air Canada (with the exception of Venice, Edinburgh, and San Jose. These direct flight routes from Toronto are actually new routes that are not flown by any other airline right now), so Air Canada would be able to save labour expenses on several of its existing routes as well.

    International Expansion

    The primary area of focus for Air Canada's international expansion is the Asia-Pacific region and the Middle East/Africa regions. Some of its plans as per its 2012 MD&A include:

    -Increased flights to Beijing and Tokyo,

    -New service to Seoul and Istanbul from Toronto

    This focus is important for Air Canada as Asia Pacific and Africa are expected to be the fastest growing regions both economically and for flight traffic, but perhaps not as important for an investment point of view, since it is expected for trans-border airlines to increase service to these areas.

    What is important, however, is how Air Canada can reduce costs for these flights, since trans-ocean flights cannot be contracted out to subcontractors who do not have the flying rights and ability to operate flights out of North America. Additionally, only experienced pilots can operate the large planes that are required for the long-haul flights. Part of the strategy to deal with this could be to raise fares. In 2012, Air Canada's revenue from its Asia-Pacific routes grew 15.6% from 2011, which was primarily due to yield growth (basically higher prices, and more seats), with 3.2% of the growth coming from traffic increase. Air Canada benefits from the solid reputation of North American regulation, especially towards emerging markets. For whatever reason, airlines from emerging markets have a reputation as being more dangerous (as an anecdote, I know people who absolutely refuse to fly on Air China, even though they have a relatively accident-free history), which provides Air Canada with some ability to raise prices. This will be unsustainable as a means for growth growing forward, as more price-sensitive customers can simply choose to fly via another airline to their destinations (i.e. Toronto-New York-Beijing), and the decrease in number customers will more than offset the higher prices paid.

    This leads to Air Canada's purchase of the Boeing 787 Dreamliner. Despite the battery issues that have plagued the Boeing 787, Air Canada currently has orders for 37 787s, scheduled to deliver between 2014 and 2019. The Boeing 787 is 20% more fuel efficient than the 767 that Air Canada uses, which is enormously important given that it will be used for long-haul flights which consume the most fuel. Although the planes themselves are expensive, it is a necessary investment for the future, as any airline that does not upgrade will be at a significant cost disadvantage. In any case, the financing for the loans are secured by the aircraft, and the financing cost will be more than made up through the tax shield through the interest and CCA, and fuel savings.

    Premium Service

    A final way Air Canada plans to grow is to focus more on premium service than pricing. This has already been taking place, evident by Air Canada's awards for its business class on its international routes (Asian airlines typically dominate the global awards, but they operate on routes that Air Canada does not fly to such as Oman, Qatar and UAE). As a whole, this is a smart decision, as Air Canada cannot possibly compete based on price with budget carriers, given the company's structure. The plans include a new premium economy class for select routes, which follows the strategy that was announced by several other international airlines. Premium and frequent flyer customers are probably the most profitable segment of all airline consumers as they typically fly more (for business), are much less price sensitive (since their tickets are usually charged to the company), and are willing to pay a premium for extra services. This strategic shift is in line with its increased Asia Pacific focus, and should result in a boost to Air Canada's margins.

    Valuation

    Air Canada would be hard to recommend using current valuation methods, as it currently has negative book value. Below is a summary of several key figures relating to its pensions and labour negotiations.

    Pensions:  
    Impact of labour negotiations with unions:- 1.1 billion
    Potential Increase in interest rates by 1%:- 1.84 billion
    Potential Decrease in Liability2.94 billion

    Although the Bank of Canada has signaled its intentions to keep interest rates low for at least another year, they will be raised eventually, which would significantly help with the shortfall. The results of the negotiations and increasing interest rates (in the future) will nearly be enough to completely erase the Shareholder's deficit. By factoring in additional savings from the above strategic changes, it is completely reasonable to believe Air Canada can have a healthy balance sheet.

    Variant View

    The most important risk is that the government of Canada does not approve the extension of the 2009 Air Canada Pension Regulations. Most analysts believe the extension will be granted.

    There are 2 reasons why I believe Air Canada's improved prospects have not been fully priced in yet:

    1)Low liquidity of its shares- Air Canada's average volume is around 61,000, as opposed to WestJet's 400,000. This is a legitimate concern, especially for investors who are looking to invest larger sums of money, but may also provide a decent liquidity premium for those who are willing to accept the risk in the longer run.

    2)Bad rap sheet- Many investors still remember Air Canada's recent bankruptcy and continuing labour relations issues, and would designate Air Canada as a terrible investment forever. Additionally, Air Canada would be skipped over by those who use stock screens and Google Finance's financial statements to search for stocks that meet certain criteria. Since most of the reasons to buy Air Canada are qualitative in nature, only those who have thoroughly researched the company would buy it. When the financial statements begin to reflect the improvements, the share price should follow.

    Disclosure: I am long OTCPK:AIDIF.

    Additional disclosure: I have no positions in WJAFF.PK

    Themes: Airlines
Back To Ernest Wong's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (2)
Track new comments
  • rocketman7
    , contributor
    Comment (1) | Send Message
     
    I beg to differ:

     

    The contracting out of pilot services poses a double-risk:

     

    1. Safety and the perception thereof: Underpaid contracted-out pilots were the primary cause of the crash in Buffalo. The contentiousness it brings goes to the second point:

     

    2. Your discounting of the importance of #4)Fostering positive changes to its culture. The English for that is "customer service." Those of us fly AC as the airline of last resort are put off by their ever grumpy, unhelpful and aggravation-causing ground staff constantly inconveniencing customers. Upset pilots over contracting out, still fuming over the merger with CP Air (!), won't add more pleasure to the flight.
    15 Mar 2013, 05:54 AM Reply Like
  • Ernest Wong
    , contributor
    Comments (53) | Send Message
     
    Author’s reply » Thanks for your comment. I am by no means an expert of the airline regulations, but I have faith in the training schools and industry regulators in Canada that produce pilots. I don't believe that most people can tell the difference between an Air Canada pilot and a non-Air Canada pilot, and I'm sure most people don't perceive Air Canada or any of its subsidiaries as a dangerous brand. For your second point, I was merely re-listing out what Air Canada posted on their annual report. We all know that Air Canada doesn't have the best front desk customer service. (I actually had a verbal argument with a staff during my check in before!). However, I don't think that a pilot that is upset at contracting out will change the pleasure of the flight. There isn't really much that he can do that wouldn't be a violation of safety standards (and as a result, his job), and it's not like he's going to swear at passengers over the intercom.
    16 Mar 2013, 11:58 AM Reply Like
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Most Commented
Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.