WestJet: Too Much Headwinds

Summary

• Aircraft fuel costs and salary expenses have grown from the prior quarter.
• WestJet is starting to upscale itself and focus on expanding its international network.
• A potential recession can derail its turnaround plans.

WestJet (OTC:WJAFF) (OTC:WJAVF) (TSX:WJA) has been facing some significant headwinds in recent months. A recent article explains how it wants to return to a healthy profitability position in 4 years. Some investors may think this may be a signal that the company may turn itself around.

My feeling is there are still too much headwinds in this company to warrant an investment at this point in time. Investors should take a wait-and-see approach on this company.

Fuel Costs and Salaries Continue to Grow

The two biggest cost items: salaries and aircraft fuel costs continue to grow, and have been growing for the past couple quarters:

(Source: WestJet Financials)

Aircraft fuel costs and salaries make up more than 50% of the total costs for Q3 2018:

(Source: WestJet Financials)

Aircraft fuel costs are dictated by the markets, so there really is no way to minimize costs here. WestJet can offset some of the fuel costs by transferring it to the consumer, but this could also cause consumers to choose other airlines. The only way WestJet can mitigate against rising fuel costs is to fly fuel-efficient planes.

The second biggest cost item is salaries. WestJet is now home to 3 unions:

• Cabin Crew Members represented by Canadian Union of Public Employees
• WestJet Flight Dispatchers represented by Airline Dispatchers Association
• WestJet pilots are represented by Air Line Pilots Association

Collectively, these unions also represent a cost disadvantage for the airline as labor costs are generally higher with unions. Also, a threat of a strike can derail a company's operations and erode its bottom line.

Overall, these two items make it difficult for WestJet to compete on cost.

Domestic Airline Market Is Becoming Commoditized

With new emerging ultra-low-cost carriers (ULCCs) in the domestic airspace, flying in Canada is becoming increasingly commoditized. New and cheaper airlines are driving domestic airfares down. Even the launch of WestJet's Swoop Airlines was a response to Flair Airlines (currently flies 7 planes) and Jetlines Airlines launching mid next year.

What this means is WestJet is forced to play a more defensive strategy at home. If WestJet cannot compete on cost, then it must compete on scale since it has a much larger network of cities it flies to. There is no way the ULCC airlines can fly to every route that WestJet is in.

Its Real Strategy is on its International Flights and Business Class

The one way where WestJet can potentially make more money is by offering more international flights and moving its product to cater to the higher end customer.

The new international routes to Dublin, Paris, and Gatwick are a way to challenge Air Canada's transatlantic business. In its forward-looking guidance, it is clear its strategy is focused on international travel:

(Source: WestJet Q3-2018)

Its domestic capacity is only going to grow by 1% to 3% by the end of 2019 while its system wide capacity will grow by 6.5% to 8.5%. This indirectly hints that international travel will be the bulk of WestJet's growth plans in the next 12 months.

In its newer planes, it plans to introduce business cabins and updating its Plus section to a new Premium cabin. Its reward program will also have a new tier: Platinum. This new program will offer more benefits and perks to fliers who are willing to pay a bit more.

What WestJet is doing makes sense. The lower end of air travel is becoming commoditized because of ULCC airlines such as Jetlines and Flair Airlines. WestJet is currently the second biggest airline in Canada, and it has the capacity to naturally become a higher end airline that flies internationally.

A Strategy Filled With Risk

Although the strategy makes sense, it is also a strategy full of risks. Aircraft fuel costs can erode its bottom line. Its unions can disrupt air travel by going on strike if they don't get the salary increases they demand. Finally, there has been a lot of talk recently of a recession coming. Generally, recessions cause people to think twice in spending on luxury. So, even if WestJet does offer a very compelling higher-end Platinum program with perks and benefits, if the fliers are reluctant to spend because of the recession, then WestJet will be flying with a lot of empty seats.

I am wary of investing in WestJet at the moment. There seems to be a lot of external factors that can potentially work against the company. I recommend a wait-and-see approach for this airline.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.