Air Canada's (ACDVF) CEO Calin Rovinescu on Q2 2016 Results - Earnings Call Transcript

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Air Canada, Inc. (OTCQX:ACDVF) Q2 2016 Earnings Conference Call July 29, 2016 9:00 AM ET

Executives

Kathleen Murphy - Investor Relations

Calin Rovinescu - President and CEO

Mike Rousseau - EVP, CFO

Ben Smith - President, Passenger Airlines

Analysts

Doug Taylor - Canaccord Genuity

Konark Gupta - Macquarie

Fadi Chamoun - BMO Capital Markets

Cameron Doerksen - National Bank Financial

Walter Spracklin - RBC Capital Markets

Kevin Chiang - CIBC

Turan Quettawala - Scotiabank

Chris Murray - AltaCorp Capital

Tim James - TD Securities

David Tyerman - Cormark Securities Inc.

Operator

Good morning, ladies and gentlemen and welcome to the Air Canada's Second Quarter 2016 Results Conference Call. I would now like to turn the meeting over to Ms. Kathleen Murphy. Please go ahead, Ms. Murphy.

Kathleen Murphy

Thank you, Mo and good morning ladies and gentlemen and thank you for joining us on our call today. With me this morning are Calin Rovinescu, our President and Chief Executive Officer; Mike Rousseau, our Chief Financial Officer; and Ben Smith, President, Passenger Airlines.

On today's call, Calin will begin by highlighting our second quarter 2016 financial performance and progress made on our strategic initiatives. Ben and Mike will then address our second quarter financial performance and turn it back to Calin before taking questions from the analyst community. We will start by taking questions from equity analysts followed by questions from fixed income analysts.

As usual, I would like to point out that certain statements made on this call, such as those relating to our forecasted costs, financial targets and strategic plans are forward-looking within the meaning of applicable securities laws. This call also includes references to non-GAAP measures. Please refer to our second quarter press release and MD&A for important assumptions and cautionary statements relating to forward-looking information and for reconciliations of non-GAAP measures to GAAP results.

I am now going to turn it over to Calin Rovinescu, Air Canada's President and CEO.

Calin Rovinescu

Thank you, Kathy. Good morning, everyone and thank you for joining us. For the quarter we reported record EBITDAR of $605 million and adjusted earnings per diluted share of $0.72 both of these measures were above consensus. We also continue to meet the new financial targets established at our 2015 Investor Day.

On a 12-month trailing basis we achieved an EBITDAR margin of 18.3% against the target of 15% to 18%. And a return on invested capital of 16.2% against the target of 13% to 16%. In addition, we remain on track to achieve the targeted leverage ratio up 2.2 times by 2018 and to realize unit cost savings of 21%, within the impact of foreign exchange and field prices by the end of 2018, when compared to 2012.

We also remain on track to achieve full year 2016 EBITDAR growth of between 4% and 8%. Our record EBITDAR results for the quarter came from both in increase in revenue and traffic as well as from our continued strong focus on unit cost improvement. We saw traffic growth in all five of our geographic markets and continue to increase our revenue base in the phase of challenging revenue environment particularly in the domestic and Atlantic markets.

Overall revenue growth also reflected an increase in international to international connecting passengers via Canada. As we continue to successfully build our main hubs as attractive and efficient options for international travellers. Air Canada and Air Canada Rouge launched 10 new international routes and 11 new transborder routes in the quarter, marking the most intensive period of expansion in Air Canada's history.

Moreover on June 30, we served more than 160,000 customers setting an all time record which we expect to surpass during the upcoming August long weekend. I'd like to thank our employees for their continued focus on taking care of our customers and for working together to help support our efforts to make Air Canada, a sustainably profitable global industry leader.

I'll now turn the call over to Ben for discussion of our revenue performance for the second quarter.

Ben Smith

Thank you, Calin and good morning. In the second quarter we saw a financial and operational results that were generally in line with our strategic expansion plan. Total passenger revenues increased $61 million or 2% over the same quarter in 2015.

We saw traffic growth of 9.3% partly offset by yield decline of 6.8%. On a stage length adjusted basis yield decreased 4.4% year-over-year. This is a year of significant transformation for Air Canada to list just a few examples, this quarter is the first complete quarter where we were entirely reliant on our new origin and destination pricing and inventory system.

During the quarter we completed the retrofit of our Boeing 777 fleet to the Boeing 787 cabin standard, inducted new Boeing 787 aircraft into mainline and retrofitted and transferred additional airplanes to our Rouge fleet. We are also driving efficiencies throughout the organisation in conjunction with our regional partners at Air Canada Express. These are all positive initiatives that support our strategy and financial goals.

As discussed on prior calls, we fully expected during the short-term our capacity growth would impact unit revenue. Yield declines are an anticipated and natural consequence of our business strategy to profitably increase long-haul international and leisure flying. This incremental capacity is at a much lower unit cost resulting in improved margins. We fully expect to see demand keep up with our capacity plans in the important third quarter, as we continue to expand on our global reach and attract new customers.

Our unit cost are coming down, as we further optimize our aircraft and flight schedules, and these lower cost assets allow us to continue on our strategic growth plan. We also continue to benefit from our new labor agreements. As part of this plan, the impact of our network and fleet on CASM will continue to accelerate and provide access to revenue sources in the form of incremental new destinations and customers, who were previously Air Canada's access was limited.

From a revenue perspective we did face some challenges in the quarter. As expected, domestic yield was under pressure given incremental market capacity, competitive pricing activities and decline in higher yielding oil market related traffic versus the prior year. However with an increasingly diversified global Rogue portfolio, we're more resilient and not as a reliant on our domestic network and we have the ability to shift capacity as appropriate to better performing markets.

Our Rouge network is becoming increasingly diverse which allows us to better manage events such as Alberta, as well as those in France, Belgium and Turkey. The revenue environment on the Atlantic was difficult with yield being impacted by increased industry capacity from Canada and the United States and competitive pricing activities on certain European services. However it is both expected and accounted for in our long-term plan.

The low cost capacity we are putting place and design to deliver strong results, as we progress with our strategy. The uncertainty leading into and surrounding the BREXIT vote in the United Kingdom also drove a slowdown in UK originating traffic. Furthermore, travel fears following events in France, Belgium and Turkey had an impact on passenger demand.

On a positive note, Air Canada and Air Canada Rouge is new and returning seasonal operations, performed well and fully met expectations. As well thanks for the fleet flexibility as a fundamental part of our strategic plan we were able to shift some capacity from the Atlantic to the comparatively stronger pacific markets for the third quarter.

And the other markets comprised of Latin and South America, the Caribbean and Mexico, we experienced the impact of competitive pricing activities driven by weaker economic conditions from point of origin in South America particularly Brazil. Given a decline in forecasted demand following the Olympic Games and the current economic environment in Brazil, we recently made the decision to suspend service to Rio de Janeiro starting this fall.

As per our plan, we won't fly what doesn't make positive returns to the network. As we have to build in fleet flexibility, thanks to latest technology and fully depreciated older planes which allow us to adjust our capacity and reduce utilization at little to no cost and we will continue to do so, where appropriate.

Air Canada Rouge and Air Canada Express are other strategic tool if we have to bend leverage lower cost capacity and lower yielding opportunities. In addition, thanks to the valuable strategic geography we have in Canada, along with best-in-class transit facilities in our hubs. We are optimizing for both local and transit passengers to and from the United States and Europe and Asia, which allows us to appeal to the most populous markets in the world, further contributing to our strategic plan and sustain profitability.

For the third quarter, we are generally seeing demand in line with our expectations. As discussed on prior calls, our capacity additions this year are mainly in international markets where we are leveraging our new aircraft, refurbished and reconfigured interiors, improving cost structure and exporting our extensive and expanding global network.

As I mentioned, we've seen significant increases in our market position versus our competitors to places like United Kingdom, France and Italy. Long-term we are now in a much stronger position to compete this increasingly globally competitive environment with a more optimized market competitively.

I will now turn the call over to Mike for a discussion on our cost performance and balance sheet metrics.

Mike Rousseau

Thank you, Ben and good morning to everyone. As Calin mentioned a few minutes ago, we reported record EBITDAR of $605 million in the quarter. A significant driver of that was our cost performance. Adjusted CASM declined 1.1% year-over-year and reflected a significant improvement to the guidance, we provided in the first quarter press release.

The better than expected result was primarily driven by lower than expected capacity purchase cost, aircraft maintenance and wages, salaries and benefit expense. Had the US - Canadian Dollar exchange rate remained at 2015 levels, adjusted CASM would have further declined and reflected a decrease of 2.9%.

Turning to fuel, we saw a reduction of $141 million or 19% from last year. On lower base fuel prices $193 million partly offset by higher consumption of fuel and unfavorable currency impact. Our assumption is to the price of jet fuel, average CAD0.55 per liter in the third quarter and CAD0.53 per liter for the full year. We continue to hedge fuel call options and as of June 30, 2016 had hedged approximately 40% of our anticipated purchases of jet fuel for the remainder of 2016 at an average West Texas Intermediate WTI equivalent capped price of $51 per barrel.

Regional airline expense decreased $16 million or 3% in the quarter reflecting the reduction in fuel cost and the impact of lower rates associated with the Jazz CPA, a portion which pertained to the first quarter. These decreases were partly offset by unfavorable currency impact and the impact of our fleet expansion initiatives in the Air Canada Express fleet. Our ability to reduce Jazz cost is result of our new agreement which aligns both our interest.

Moving onto wages and salaries, this expenses increased $28 million or 6% year-over-year on higher average salaries which reflected the impact of our new collective agreements concluded in 2014 and 2015.

An increase in crew training cost associated with our new Boeing 777 aircraft and a 5% increase in employee levels versus same quarter 2015 comprised of front line increase directly supporting our expansion. We implemented several productivity initiatives to offset the increase including a 5% reduction in management employees. On a unit cost basis wages and salaries expense improved 4.1% versus last year.

An increase in aircraft maintenance expense of $49 million or 26% year-over-year was driven by an increase in end of lease maintenance revisions, which is largely due to having fewer aircraft lease extensions versus last year and by unfavorable foreign currency impact.

A lower volume maintenance activity was a partly offsetting factor, looking ahead we expect full year aircraft maintenance expense to increase $165 million from 2015, an improvement of $25 million from our prior guidance. Consistent with prior quarters, ownership cost comprised of depreciation in aircraft rent increased in the quarter. This is an outcome of our fleet renewal strategy an increase in expenses related to our aircraft refurbishing programs, additional lease Airbus 312s and Boeing 767 aircraft and unfavorable currency impact.

We've taken delivery of nine Boeing 787s and two Boeing 777s since the start of the year and we do not expect to introduce any more aircraft into the operating fleet until next year. We've also completed the conversion of our Boeing 777 aircraft into a more competitive configuration and support of our business strategy. Other significant cost areas are discussed in our second quarter MD&A.

Turning to our CASM guidance, we are forecasting a third quarter adjusted CASM decrease of between 5.5% to 6.5% when compared to the same quarter 2015. Foreign exchange is not expected to have any impact in the third quarter relative to last year's third quarter. For the full year 2016, we expect adjusted CASM to decrease between 2.75% and 3.75% in the full year 2015. This is an improvement from our previous full year guidance and driven by our better than anticipated cost performance in the second quarter and to our lesser extent [ph] we expect to continue benefit of lower regional expense into the second half of the year.

The value of the Canadian Dollar remained at 2015 levels. Adjusted CASM for the full year 2016 versus the full year 2015 will be projected to decrease 3.75% to 4.75%. We've made certain assumptions as part of these forecasts which are discussed in the new release we issued this morning.

Moving onto the balance sheet and liquidity, our unrestricted liquidity level of $3.4 billion at quarter end was at highest ever. Net cash flows from operating activities of $657 million improved $145 million versus the same quarter in 2015. Primarily in higher cash inflows and working capital and lower pension funding payments.

Negative free cash flow $444 million declined $746 million from the prior year's quarter due to the higher level of capital expenditures. Partly offset by proceeds of $351 million in sale lease back of two Boeing 787 aircraft and by the impact of higher cash flows from operating activities.

In the first half of 2016 capital expenditures amounted to $2.6 billion, which is the heaviest CapEx period in the entire fleet into the program. Adjusted net debt increased only $549 million from year end to $6.8 billion despite this high investment in our fleet. Adjusted net debt to 12-month trailing EBITDAR ratio increased a modest 20 basis points to 2.7.

We achieved a return on invested capital 16.2%, 688 [ph] basis points higher than our weighted average cost of capital. This is also above our stated goal of achieving a sustainable ROIC in the 13% to 16% range over the 2016 to 2018 period.

Additional details on our results for the second quarter can be found in our financial statements and MD&A, which were posted on our website and filed on SEDAR this morning. And with that, I'll turn it back to Calin.

Calin Rovinescu

Thank you, Mike. As I mentioned at the outset, our record EBITDAR results this quarter came from both increases in revenue and traffic, as well as from a significant reduction in unit cost while managing our adjusted CASM better than forecast.

Despite of numerous factors not in favor this past quarter including several macroeconomic and sociopolitical events that have impacted the world economy and our industry in particular, we have continued to deliver positive results. This is due to three things that we've been working very hard to achieve over the last several year. One, our overall flexibility as an organization to adapt to conditions in a marketplace. Two, our resiliency and capacity to weather these changes and three, our determination to stick to our long range strategic plan and continue to deliver sustained profitability regardless of any curve balls thrown at us.

The challenging revenue environment has post some obstacles which we are much better positioned to overcome, be at the recent uncertainties in Europe and cities like Paris, Brussels, Istanbul or Munich or the situation in Fort McMurray in May. These situations require humanitarian responses which we are proud to deliver and also operational ones.

It is testimony to the skill and expertise of our people that we've been able to navigate these particularly complicated situations, with such professionalism and reiterate all of our 2015 Investor Day targets as well as our projected 2016 EBITDAR growth of 4% to 8%. In the face of the variety of macroeconomic and geopolitical factors, we've stayed the course and still increase passenger revenue where many legacy carriers saw revenue reductions in the same period.

Our flexibility as well as the greater proportion of our owned fleet provide us significant risk mitigation if required and our launch of 10 new international routes and 11 new transborder routes, have allowed us to meet our growth priorities internationally. Part of our long range plan is also to strategically invest for the future. We achieved our record EBITDAR and a record level of liquidity despite having invested heavily in new equipment, with over $2.6 billion in CapEx in the first six months as Mike mentioned mostly for new generation aircrafts.

This is to ensure that we have one of the youngest and most productive fleets in the sky and we intend to press this advantage, as we take delivery of the last of the 37 Boeing 787 Dreamliner aircraft we have on order. Complementing these will be our new narrow body aircraft including the delivery of our Boeing 737 MAX starting in late 2017 and the Bombardier C series starting in late 2019, which as you know we firmed up in this quarter.

As we have said repeatedly, totaling 90% of our growth will be in international markets. Over the last several years, we've added to our network new destinations all over the world including places such as Athens, Amsterdam, Barcelona, Copenhagen, Delhi, Dubai, Edinburgh, Tokyo/Haneda, Istanbul, Manchester and Venice.

This past quarter alone, we launched new routes including Glasgow, Leon, Budapest, Warsaw, Prague, Casablanca and Brisbane. Overall demand remains in line with our expectations and with our competitive pricing and strategic deployment of Rouge flights we are meeting expectations with these markets to-date.

We are also very confident that we are firmly on the right track and by staying committed to our strategic plan, we will continue to build a resilient company that is consistently profitable for the benefit of our shareholders both now and into the future.

I'm immensely proud of our leadership team and all of our 30,000 employees for rising to the occasion by involving our work practices and improving our culture as we navigate the exciting path ahead toward a brighter future for our company.

Thank you for your attention and we'll now open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] our first question is from Doug Taylor from Canaccord Genuity. Please go ahead.

Doug Taylor

I realized you said demand in Q3 so far is in line with your expectations for Q3, most North American carriers are pulling to another step towards stabilizing yields in the third quarter, acknowledging that Air Canada's portfolio is unique on a geographic basis. Could you comment on whether you expect your own yield should take another positive step forward in Q3?

Calin Rovinescu

Good morning, Doug. As you know, we are not giving any yield or RASM guidance at this stage and you're absolutely right that for pointing out that our model and our business line is difference then many of the North American carriers that are basically continuing to progress their plans as for the past and in our case we're launching this massive expansion Bruges, lots of international flights. Stage length increases etc.

So in our case, the demand curve has continued to stay quite strong and we are very pleased with what we are seeing right now for the third quarter and we confirm our EBITDAR guidance which is from our perspective as we looked at, what was going on in this past quarter. There are various points in time, where we are going to wonder whether or not that would be the case but right now we continue to be confident of our 4% to 8% EBITDAR growth over last year.

Doug Taylor

Okay, that's helpful. You've been vocal about the number lease aircraft and expiring leases you've got in the next 18 months, as a key source of flexibility. I'm wondering as you're lapping new leases, what kind of terms are you looking for as you're extending these short-term extension, similar rates you're looking to lock these down for longer terms at lower terms. It'll just be helpful in helping us think about your capacity in the next year.

Mike Rousseau

Doug, this is Mike. So as you know we're going to fairly significant narrow body transformation starting late next year. So that majority of our narrow body lease extensions are to tie in to the delivery schedule of our new 737s coming in.

Doug Taylor

So shorter.

Mike Rousseau

Short-term.

Doug Taylor

In nature. Okay.

Mike Rousseau

Yes, absolutely.

Doug Taylor

That's helpful. I'll pass the line.

Operator

Thank you. Following question is from Konark Gupta from Macquarie. Please go ahead.

Konark Gupta

So couple of questions here, first on CASM, Mike. The full year CASM guidance was improved by 100 basis points, which I think probably implies roughly $100 million in incremental cost savings buying back [ph] so what are the key drivers there and how much of that looks sustainable to you?

Mike Rousseau

First of all we believe all of its sustainable, a lot of the keys in Q2 and then some of it will also come from ongoing savings from our recent negotiations with Jazz on the annual reset program.

Calin Rovinescu

One of the benefits, Konark. It's Calin here. One of the benefits that you should think through when you're modeling going forward is that, when you look at the transformation that occurred as a result of that Jazz CPA, it's very significant not only in respect of the benefits we received through the restructuring of the CPA and the pilots to flow up agreement and so on, but as a result of the changes that occurred to it, it has given us other opportunities to tackle other cost in the structure and a stronger and improved relationship which Jazz has given us that ability and therefore, now this is sort of one of the good hidden benefits that came out of the restructuring of that contract.

Konark Gupta

Okay and thanks for that Calin and just following-up on that on the maintenance side. So the maintenance guidance now suggest the cost will be up $165 million year-over-year and if I'm not wrong in February, I think you said it will be up $250 million, so net-net this and there's $85 million saving there. So what's going on with the maintenance cost here, are you moving around some buckets here or are you kind of realizing some benefits from your agreement with I don't like with Boeing or other maintenance providers. So can you please provide some color on that?

Mike Rousseau

Yes, the key driver. I think part of it is exchange rate, but a key driver that's sustainable, is the fact that our maintenance department has been renegotiating contracts long-term maintenance contracts with a variety of suppliers and we've been able to negotiate deals that are frankly better than what we had before and so you're starting to see the benefit of those savings and that's reflected in the guidance for the year.

Konark Gupta

Okay, so you don't anticipate, Mike these maintenance costs to catch up at some point in the future period?

Mike Rousseau

No.

Konark Gupta

Okay, thanks and what's holding you from raising the EBITDAR guidance when the costs are coming down, like did you see any incremental yield pressure, revenue pressure which is sort of why you don't want to kind of be aggressive right now.

Calin Rovinescu

No look, Konark. It's Calin here. The comments you made about the overall state of the economy and the geopolitical outcome especially in places like Europe and you've seen some of our European colleagues cautioning us to what they expect over there. So our perspective is, we're operating in a somewhat uncertain world, but based on what we're seeing for our business from our geography it continues to be quite strong, but it is a reasonable expectation to have this 4% to 8% EBITDAR growth and of course you remember that, that is on top of last year's record EBITDAR. So we're talking about topping last year's record not just any old year, so to speak.

Mike Rousseau

Konark, this is Mike. I'll just add one more or two more things. One are, our assumption for fuel is a little bit higher at the end of Q2 then it was in Q1 so that is a factor and two, we're going into our biggest quarter Q3 and so, we will certainly revisit the guidance post Q3.

Konark Gupta

Okay, thanks Mike and finally on the CASM outlook, Mike. I know you're expecting or you are targeting 21% CASM production by 2018. If I'm not wrong, you're probably halfway there now, three years or more than three years into it and what do you think you need to do more here to kind of get the remaining half or do you think whatever initiatives you have taken so far are enough to drive that remaining half improvement.

Mike Rousseau

What we believe the initiatives, primarily the fleet initiatives that we have in front of us will cover the rest of that 21% but that doesn't mean that we're not going to stop looking at opportunities to, for efficiencies and for example, the recent one we did, where we took out 5% management head count that wasn't part of the 21% and it just shows the focus we have on cost reductions programs within this company.

Konark Gupta

Okay, thanks for the color, Mike. Thanks.

Operator

Thank you. The following question is from Fadi Chamoun from BMO. Please go ahead.

Fadi Chamoun

I would like begin to the Atlantic RASM a little bit which was down 9.9% in the second quarter was this a function of sort of ramping up capacity [technical difficulty] is it really sort of an [technical difficulty] environment sort of update and I'm trying to understand how should we think about the Atlantic [technical difficulty] given sort of what outcome you had in Q2?

Ben Smith

Hi, Fadi. It's Ben. Calin mentioned at the beginning of the call, we had a significant expansion on the Atlantic that started in the latter part of Q2 and in addition to that, we started to see the deployment of the new retrofitted 777s that added many seats, 51 seats to our 777-300ER's and 30 seats to our 777-200's as well as the continued reconfiguration from mainline to Rouge of our 767's which added approximately 70 seats on those airplanes. So the CASM from a seat perspective on all three of those fleet types came down and the expected RASM on the Rouge when we deployed those airplanes came in at a reasonably expected level now.

As you've heard throughout the call, we did have or we did face a lot of headwinds with some of the events that took place in Europe, there is increased capacity on the Atlantic but considering everything that we have going forward and that we put into the market. We are reasonably pleased with the performance. The 777 reconfiguration actually completed in Q2 and the full benefit of that will start to see effect in Q3.

So we're really going to look forward to have, our new 777 fleet as well as the increased Rouge fleet performs in Q3, but just to draw down little bit further on your question on RASM. I guess this is part of our plan, we're accessing lower yielding opportunities with even lower CASM tools searching for increased margin opportunities which we are delivering on and to relate, we're looking from 4% to 8% EBITDAR improvement by the end of the year.

So this is the first quarter that Q3 is looking quite strong, you said demand is holding up. The RASMs that we're expecting to see are coming in line give or take a few percentage points, but that is expected.

Fadi Chamoun

Okay and maybe just one follow-up on the same topic. So should we think that sort of the supply demand or that the low factor I guess into the third quarter is going to be reflective of sort of stronger sequential demand like anything on the sequential RASM that we should be thinking about is it, supported by higher load factor in Q3?

Ben Smith

I think that what we're focusing is the bottom line margin and we want to make sure that it's sustainable. So we're managing our capacity between main line and Rouge with the opportunities in the market place and the competitive response to ensure that we get a margin expansion that we believe is sustainable long-term. So whether it's low factor or its yield or where we deploy the capacity, at the end of the day what we're looking for from, you know a total system basis and particularly the Atlantic.

We want to ensure that, we can show an improved margin on sustained basis. Though, we have a blip here and there with some of the hurdles that you're seeing but that is our continued strategy.

Fadi Chamoun

Okay, thank you. Appreciate the color.

Operator

Thank you. The following question is from Cameron Doerksen from National Bank Financial. Please go ahead.

Cameron Doerksen

Just a question on the I guess the cost, is there any way you can maybe give us what the annual, what your expected annual savings might be from the reduction in the NAV Canada fees and is that baked into your guidance for the remainder of the year?

Mike Rousseau

Hi, Cameron it's Mike. So we're very pleased to see that Canada returning some of the surplus, it is from our perspective a one year benefit. It will start, I think in September of this year and I think the rough number for Air Canada is $30 million, but it will go from September 2016 to September 2017. And obviously that the pro rata portion for 2016 is fairly small amount, that's built into our guidance.

Cameron Doerksen

Okay, very good. And just maybe secondly just talking about the yields. I'm just thinking about the domestic market. Obviously there has been some weakness there but we're seeing your main competitor trim some of their capacity plans in the back half of 2016. What are you seeing with domestic yields? I mean is it, has it stabilized you see that worsening in the second half.

Ben Smith

Hi, Cameron. It's Ben. We do see improvement and we're expecting stabilization and if that doesn't happen, we'll make the necessary adjustments.

Cameron Doerksen

Okay, that's all from me. Thanks very much.

Operator

Thank you. Our following question is from Walter Spracklin from RBC. Please go ahead.

Walter Spracklin

Just wanted to start here on, to clarifying your CASM reduction on your guidance, was that entirely due to a lower cost or and so nothing to do with any higher than expected capacity coming on from where you were at the [indiscernible]? Is that right?

Mike Rousseau

Yes, Walter it's Mike, that's absolutely correct.

Walter Spracklin

Okay.

Calin Rovinescu

Walter and in fact we're - there are some tweaks on the reduction size as oppose to tweaks on the increase size as far as capacity is concerned. Such as Rio is a good example of that and obviously we had trimmed some things Intrawest as well before and you've seen the announcement on Rio.

Walter Spracklin

So you're saying that, had you given capacity guidance at the beginning of the year, the guidance would have been tweaked downwards with this result.

Calin Rovinescu

Slightly, we did add the, what we think is going to be a very lucrative route, which is a the Vancouver - Delhi route which will start later this year as well.

Walter Spracklin

Got it and without having that guidance we're relying on I guess something third-party sources now that indicate capacity for Air Canada will be quite strong, quite high in the back half. You had indicated that demand is strong, but everything is relative obviously and with the mid-to-high teen capacity indications. Are you saying that demand is strong enough to handle the capacity you're bringing on in the back half?

Calin Rovinescu

Yes, leading the witness, but the answer to that is yes. Walter. So let me rephrase a little bit, what Ben said, you're touching on a very important point here. So yes we're confident that this amount of additional capacity putting in the third quarter is going to be filled profitably and remember, our eye is on the ball as Ben said before of margin expansion and so we're not, as I said on prior calls we're not chasing RASM, we're not chasing yield, we're not chasing load factor, we're chasing margin expansion, bottom line margin expansion and so we're confident that we'll be able to profitably fill this increased capacity as we're filling out the rest of our network.

We've added 10 new international routes in the second quarter and so we're obviously in a position where we appreciate that, we're setting some pretty high hurdles for us to fill the seats, but we're - demand is continuing to be strong in light or despite this additional capacity addition, where we're quite pleased with what we're seeing.

Walter Spracklin

Okay, great. Now that gives me comfort on the near term. I'd like to go out a little bit longer term because I think there's some, there's a few very significant events that are lining up for you late in the decade that will be quite substantial in terms of their impact. I would say and one of them of the CPA agreement with Jazz. Now you mentioned the $550 million benefit that you're going to have up until 2020, but Jazz is already disclosed that there's going to be a cut of upwards of half the rate in which they're charging you post 2020.

Mike, is it just essentially going into that CPA line ex-fuel and cutting that in half, should that be how we're looking that in 2020 for those that look at Air Canada perhaps on a longer term DCF basis or normalized post-2020 earnings basis.

Mike Rousseau

Walter it's Mike, that's absolutely correct.

Walter Spracklin

Okay. And then you've got AIMIA that and correct me if I'm wrong, they're about 9% of your capacity allocated to the Aeroplan program. And then, a meaningful discount to your prevailing market price on that which was contract signed by another party, ACE Aviation in terms of that being done. Are those metrics right? Is that 9% a double digit discount and am I wrong in expecting that when this expires there could be significant movement in that contract to your favour in 2020.

Calin Rovinescu

Again Walter that is correct. In that color, we have a great relationship with AIMIA and Aeroplan and we're open-minded to good negotiation there but there's no question their expectation will be that, anything that is a below market, the term will be brought to market and we'll be able to exploit the benefit of our assets which include the inherent benefits of our loyalty program. And so the expectation is indeed that 9% should have a significant uplift.

Walter Spracklin

Absolutely. Okay and then, obviously by then you're toward the end of your major capital spend and Mike you've guided us to about $1 billion maintenance replacement CapEx cost. So that's on this run rate, you know it's $2.5 billion lower than where we are today.

Mike Rousseau

Yes, that's absolutely correct.

Unidentified Company Representative

And I think you know Walter, we've been fairly transparent with the marketplace. We show CapEx programs over the next couple of years and we're going, obviously we're investing in the future. First half of this year was again, as reiterate what Calin and I said $2.6 billion is the heaviest capital expenditure program for a six month period probably in the history of the company. And its' what's doing all the right things it's positioning us for the future and positioning us to generate significant free cash flow as we get closer to the end of the decade.

Walter Spracklin

I guess on that and most of your guidance or your long-term targets go to 2018 that do not capture any of those fairly meaningful items. Can we foresee or do you envision with your next iteration of your long-term guidance when we start to see it pushed out to 2020, so we can get a line of sight into some of these benefits.

Calin Rovinescu

Yes, we're planning to have another very successful Investor Day probably early next year or mid next year and we will take the guidance out another couple years.

Walter Spracklin

Perfect. Okay, that's all my question.

Mike Rousseau

Once again, Walter. Here. I want to Ben to comment as well on one of your earlier questions.

Ben Smith

Hi, Walter it's Ben. Just to your question on the capacity that we have second half of this year. We're actually quite excited about what we have in the market. It's been many years that we wanted to serve a lot of these routes but did not have the cost effective tools to do so and with all the other questions you've been asking here. We're walking a tight rope here doing share that as we have this capacity, we are delivering year-over-year margin expansion while positioning ourselves to be in a much strong position medium and long-term.

So all the moves that we are making, they're designed to be done, a way that we can withstand some of the events that we're seeing and they're expected, we're built in that kind of buffer and ensuring that we can delivery year-over-year margin expansion while at the same time, align a company for longer term success.

Walter Spracklin

Makes a lot of sense, Ben. Appreciate your answers.

Operator

Thank you. Our following question is from Kevin Chiang from CIBC. Please go ahead.

Kevin Chiang

Maybe just turning to your various markets. I did notice in your MD&A, that you did highlight a competitive pricing as a headwind to yields and I think each of your markets that you service and I'm wondering if you're seeing, let's call them more irrational behaviour given the lower field price environment or whatnot. When it comes to the capacity to competition in roads you're expanding, are you seeing a little bit more than you would have saw say maybe 12 to 18 months ago or maybe I'm reading too much into this comment.

Calin Rovinescu

I'll ask Ben to comment, there's been new competition as well that has come into the market which we reference over the Atlantic, but Ben go ahead.

Ben Smith

Sure, Kevin I think what we're seeing is, the type of tools that we have now at our disposals the lower cost Rouge platform and the much more competitive 787 and 777's that we have at our disposal, the reaction we're seeing for our competitors some of them are little slower than we like, but once I think they understand that we are not deploying capacity in irrational way and that we are looking for margin expansion and that we have the resilience to hold a stronger market position. We expect to see the necessary moves by those less that the, that is more or less strong enough.

We encounter irrational competitor and if we do in the future. If required we'll make the necessary adjustments to ensure that it does not effect our stated goal achieved in 4% to 8% bottom line expansion.

Kevin Chiang

That's helpful and maybe just following up on that, provided good detail on what you think your market should be on sixth freedom traffic, you've noted anecdotally some of the leisure markets, you can compete in now with your lower cost structure. I'm just wondering when you look out across globe I guess are there markets or routes you see today in which you're not getting your fair market share, maybe not market share that you want to expand into, that you have envisaged as you roll with this new fleet, are there new routes we can look forward to seeing over the next call it, two to three years here.

Calin Rovinescu

Obviously we're not going to announce new routes on this call but remember that number that we've often cited is a great measure as you look at the US market to international destinations by international carriers and we still have a very small share of that, that is a huge market opportunity for us and so this is taking traffic from the United States over Canadian hubs into international markets and so we have many, many international markets and many of the ones that you've seen that I listed here in my earlier remarks are markets that we are getting a lot of that type of feed from the United States and so, we're still relatively early in the Asia strategy at this stage.

Now we're flying to Beijing and Shanghai for example in China, but obviously not many great opportunities in China with the past of time opportunities for increased flights to places like Beijing, where there is a big opportunity other places in the Middle East, so without announcing any new routes suffice to say that, we have many more opportunities and our universe of customer is not restricted to the population of Canada.

Ben Smith

Yes, Kevin just one more note there. We do see many, many opportunities throughout the world for us to expand, we're not looking for market share sake alone. Sometimes it is important that at the number one priority for us is bottom line expansion and sustained long-term bottom line expansion. So if getting a stronger market position falls into that strategy, we will do so root-by-root or market-by-market. I think we're definitely market share driven purposes alone.

Kevin Chiang

That's helpful, maybe just last one from me. You did complete a sales lease back in the second quarter just wondering have you and apologize if this is in the MD&A, but have you finalized your thoughts on potentially sales lease back in 2017 has that been decided on yet at this time.

Mike Rousseau

Hi, Kevin it's Mike. I think we're bringing in, eight to nine planes 787's next year and some of those will be probably a sale lease back as well. As I said, even we swim into this financing program for 787's majority will still be debt finance because we want to own these planes but some of them will be sale lease backs as well to balance the cash flow.

Kevin Chiang

That's helpful. Thank you very much.

Operator

Thank you. Following question is from Helane Becker from Cowen & Company. Please go ahead.

Unidentified Analyst

Hi guys, this is actually Connor in for Helane. I just had a question about Latin America. So numerous [indiscernible ] US carrier have been deciding Latin America is an improving market, given the overall industry capacity reductions there. I know you guys trimmed Real, but I believe you're still growing into that market has there been any improvement in the yield environment or maybe the demand side, given the slowing capacity or do you kind of view second quarter as the bottom there and we're going to start to see some sort of sequential improvement?

Ben Smith

Hi, it's Ben. No we still see South America in particular deep South America, we refer to as Brazil in particular and Chile and Argentina as challenged markets and we do now have more flexible gage to right size the capacity and unfortunately we couldn't find a rotation that could make sense post Olympics to keep Rio de Janeiro going so, we've made into temporarily suspending that route until Atlantic [ph] market conditions improve.

Unidentified Analyst

Okay, great. And then in terms of the European market, so obviously this is kind of longer term deal. I mean I know there is lot of uncertainty there just given BREXIT and the overall economy has your long-term thought plans changed for that market at all potentially delaying routes, so you six months ago, that you were previously were going to potentially launch longer term.

Calin Rovinescu

No, longer term absolutely not. It's a strong market for us and it's a strong business market and it's a strong leisure market and between the main line and the Rouge product we have huge expectations for that market.

Unidentified Analyst

Has there been more a shift to Rouge rather than the mainline just given kind of the uncertainty there or not really?

Calin Rovinescu

No, no that's not a factor that we've applied in terms of deciding which Rouge routes, the Rouge routes have, have been routes that are fundamentally leisure oriented there are couple that are kind of close to the line and we had some good discussions as to whether those are more main line or more Rouge oriented but none of the BREXIT related short-term type of macroeconomic events of influence start thinking on whether to designate as a Rouge route or not.

Unidentified Analyst

Okay and then just a housekeeping one, so you decided this like increased stage length of the second quarter negatively impact yields by 2.4 points. Do you have, is that kind of a good run rate to use for the third quarter or should we expect that to increase a little bit, just given the fact that you're growing little bit more at that time.

Mike Rousseau

Connor, it's Mike. Off top of my head, I'll say this proxy [ph] for Q3 but we can follow-up with you, if number is materially different but I don't think it's going to be materially different from that stage length in Q2.

Unidentified Analyst

Okay, great. Thanks guys.

Operator

Thank you. Our following question is from Turan Quettawala from Scotiabank. Please go ahead.

Turan Quettawala

I guess I wanted to just focus a little bit on the business cabin here. You mentioned in the MD&A that traffic was up about I think 3.8% in the quarter on the premium cabin. I know the capacity is going to be added in the bunch of different areas, lot of it obviously is Rouge. Can you give us a sense of where the premium load factors were up or down in the quarter?

Ben Smith

Hi, Turan it's Ben. We saw some pressure on premium cabin low factors, most noticeably in and out of Alberta, the rest of our network was in line with our expectations.

Turan Quettawala

Okay, thank you Ben and then I guess also yields were down on the business cabin in the quarter. I think that haven't been the case for a while. Can you comment a little bit on how that's trending in Q3 and do you think this is just mainly like a bunch of macro events in I guess Alberta or is it, do you think a precursor into a tougher kind of economy here?

Ben Smith

No, I think at this point what we're seeing is, sort of happened in the past as well, is when there is a reduction in the price of fuel, we see a more obvious correlation with some business price. Hard to say here or there, but as I said it's, we'll adjust what's hyping [ph] there to ensure we meet our bottom line, there is nothing material as concerning as of this point with the premium gap [ph].

Turan Quettawala

Got it okay and I guess maybe just one more on the London route. Obviously there's been a lot of competition there, can you talk a little bit about maybe Gatwick how that's doing and how is that maybe having some impact on Heathrow at all, are those sort of both distinct markets for you?

Ben Smith

I can tell you this, we are very pleased with our point of sale Canada new mission, all Rouge in missions, they're all performing at or above expectations including Gatwick.

Turan Quettawala

Okay, great and nothing on Heathrow I guess.

Ben Smith

And in terms of impact on Heathrow, we'll see no correlation.

Turan Quettawala

Okay, that's great. Thank you.

Operator

Thank you. Our following question is from Chris Murray from AltaCorp. Please go ahead.

Chris Murray

Mike just thinking about CapEx and your debt levels right now. So 2.7 times at the end of the quarter and that's of course is been creeping up, but as we think about the back half of the year now, your CapEx spending steps down I think it was just over $400 million. Shouldn't we thinking that this was really the inflection point where you start stepping back that leverage back through back end of 2018 with your 2.2 target.

Mike Rousseau

I think it was a fair statement, Chris. Again, I'll reiterate spending $2.6 billion capital in six months was a fairly large amount of work for us and certainly influence couple key measurements such as leverage ratio. So as we step down the CapEx program just not in the second half of this year but into the next year and the following year and as we start generating better returns from that new investment, certainly our leverage ratio, we expected it to decline.

Chris Murray

Okay. And along the same line, the resumed free cash flow start stepping up.

Mike Rousseau

Absolutely.

Chris Murray

Okay, so that brings me to next question. So with record cash and probably fair amount of free cash flow generation, really what's the thought process around use of those proceeds. I mean certainly the repayment of debt but you're growing into the debt profile as you said, anymore thoughts I mean on the share buyback to get more aggressive there and I guess you still have some debt that's outstanding there's some stuff you can retire that way and lower you cost to capital further.

Mike Rousseau

I think we remained consistent in our view that debt reduction is a key objective for us. We do believe that creates values to the enterprise and to our shareholders. As you know, we upped our normal course issuer bid to the maximum amount of 10%, which started a month ago and so, as we talked by 2018, we want to get to leverage ratio of 2.2 and so as we talk about the past, the cash flow will be to finance the rest of the capital expenditure program and reduce leverage ratios to numbers that we think are more reasonable.

Chris Murray

Okay, thanks guys.

Operator

Thank you. Our following question is from Tim James from TD Securities. Please go ahead.

Tim James

Just want to talk about any of the notable competitive responses you're seeing in the market either currently or expecting going forward and putting aside your primary, domestic competitor and we're well aware of kind of their initiative into the London market, but I'm thinking outside of that. Are there any notable moves that you're seeing or creating. And I'm not necessarily saying unexpected even expected competitive responses, but if you can just talk or discuss that please.

Ben Smith

Hi, Tim its Ben. We're seeing because of the weakness in the Canadian Dollar some removal of capacity by the US carriers into [indiscernible] Canada on the transborder that's happened historically, so that would be expected when the dollar has material shift. The other thing we are seeing is, Air Transat which over the last 10, 15 years has been adding a significant amount of transatlantic capacity almost every single year that is pretty much flattened out. So that for us is a good sign and other than that, Pacific continues to be very competitive and the legacy carriers from Europe also very competitive and we're seeing some low cost competition with stop overs in - originating in Iceland, which is HB [ph] Europe, stopping in Iceland, coming into North America we're seeing that phenomenon play out, but so far it's a very limited amount.

Calin Rovinescu

And Tim it's Calin here, I would add one other thing when you're thinking of the full competitive question. Rouge was exactly designed for this, this is the idea. Right, so that we know that there are some leisure markets are some hybrid leisure business markets, where we could not adequately compete with our prior product and now all of sudden, we have this product which is as I said, in the past is been knocking it out of the park in terms of both natural performance and you know sort of speed to enter market and so it is a different dynamic for us.

It doesn't mean, you're not going to see in some markets increase competition overtime for sure you will and as I said previously competition makes us better, makes us stronger but Rouge has given us in many of these markets that Ben is referring to, Rouge has given us the competitive element that we didn't have previously.

Tim James

Okay, thank you and just thinking specifically about the Haneda market and some of the new slots, the US carriers are getting. Do you think that will kind of infringe it all on the profitability or the revenue potential for Air Canada into that market specifically?

Ben Smith

On Tokyo, we're very pleased with our performance, the US carriers or Japanese carriers were flying services into Haneda right from when we started, they just did not have the lucrative time slot that we had. So we've from the West Coast obviously that wasn't relevant, from the East Coast I think what we're seeing point of sale US business traffic was preferring to say non-stop ii Bay [ph] market in Narita so we don't see that materially effecting us.

Overtime if Haneda does open up to more slots where it becomes more of the hub into Asia, we'll have to relocate our Narita capacity, for that makes sense in the current form.

Tim James

Okay, thank you and then just my last question. I want to return to the Aeroplan program and the potential savings there for a minute. How do you balance the financial benefits obviously of raising the cost of seats to Aeroplan with the potential negative impact on the value proposition that your customers get from the program which is obviously significant.

Calin Rovinescu

It's still early days to sort of speculate what the new arrangements would be, but remember we've been developing the altitude program over the last number of years to identify the main driver being people who are frequent fliers on our carriers as opposed to frequent spenders on credit cards or in other context and we'll continue to design programs that are attractive for those who fly the most on us.

And that's an important distinction that we'll look forward as further develop strategies around the program.

Tim James

Great, thank you.

Operator

Thank you. Our following question is from David Tyerman from Cormark Securities. Please go ahead.

David Tyerman

The first one on the wide-body's you've 13 more planes, so quite a bit more going into winter season. I was wondering if you could comment on how you see deploying a bunch of more capacity.

Ben Smith

Hi, David it's Ben. What we're doing, we're doing a number of things with the fleet. Some of them for first time in many, many decades. A big portion of the Rouge, 767 fleet will shift from transatlantic markets to Florida, Las Vegas, Phoenix, Hawaii, Caribbean, Mexico that's already for sale in the channels. These airplanes perfectly sized, some of the routes will be single rotations on double and then you'll see the uptick in from 767's to 787 on some of the routes that where we previously would have operated that type of aircraft.

We are also increasing capacity from Toronto to Delhi from four times a week to daily and we're also increasing or introducing service as Calin mentioned from Vancouver to Delhi and you'll see some increase in capacity in the form of additional seats on the same aircraft types on existing routes.

David Tyerman

Okay, that's very helpful. And then the other question I had was just on Rouge. So you're, next year you'll be coming closer I think the original target size or what you were allowed to do. I was just wondering if you could comment, how you see Rouge unfolding beyond 2017 in a broad sense?

Calin Rovinescu

When we get to 50 level, we'll have some discussions with our pilots, we've obviously established great working dynamic with the pilot group and I think that many of our pilots have seen some of the benefits to the pilot group and to the company from having established and deployed Rouge. So we'll have once we get to the 50 or near the 50 level, we'll have further dialog and see where that takes us.

David Tyerman

Okay, so reading between the lines. It sounds like you don't feel that Rouge is tapped out, that there is more potential beyond the 50.

Calin Rovinescu

You know it's early to say, really I mean this is been the great thing that's come out of our relationship with the pilot group, that we can have this kind of dialog and come out with win-win scenario, so I don't want to speculate David as to whether we'll go beyond 50. I think that there's certainly a business case to be made for it and we'll look to have that discussion in the fullness of time.

David Tyerman

Okay, very good. Thank you.

Operator

Thank you. The following question is from Konark Gupta from Macquarie. Please go ahead.

Konark Gupta

Hi, Mike just a couple of follow-ups on the prior comments. So on the sales lease back, have you baked in any of the future sales lease backs into your CapEx guidance or will that be an offset?

Mike Rousseau

No, we've assumed in our MD&A schedules that we purchase everything.

Konark Gupta

Okay, sales lease back would be a cash inflow.

Mike Rousseau

Absolutely.

Konark Gupta

Okay and what was the $150 million proceed from sale of asset in second quarter.

Mike Rousseau

That was the remaining Embraer 190's as part of 737 deal, we sold 20 of them to Boeing and that was the remaining portion.

Konark Gupta

And that's done, right?

Mike Rousseau

That's done.

Konark Gupta

Thanks. That's it from me. Thank you guys.

Operator

Thank you. We have no further questions registered at this time. I would now like to turn the meeting back over to Ms. Murphy.

Kathleen Murphy

Thank you, Mo and thank you everyone for joining us on our call today. Thank you very much.

Operator

Thank you. The conference has now ended. Please disconnect your lines at this time and we thank you for your participation.

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