Air Canada’s growth strategy looks like it’s finally set to pay off
By any measure, Calin Rovinescu and his team have accomplished a lot in his seven years as chief executive of Air Canada. Labour peace, a pension surplus, a comprehensive fleet overhaul, a new leisure carrier, new contracts with regional partners, huge international growth, a successful debt refinancing — the list goes on.
Investors, however, have never been totally convinced that Rovinescu’s strategy is the right one. Despite 16-fold growth in the airline’s share price since 2009 — from a low of 78 cents on April 1, the day Rovinescu took the helm — the stock still trades at a discount to its U.S. peers.
“Why is it so cheap? Perceived risk from overexpansion, overinvestment and leverage,” Credit Suisse analyst Julie Yates wrote in a recent analysis that initiated coverage of Air Canada with an outperform rating and a price target of $17.
In other words, investors have been worried that Air Canada is expanding too fast, spending too much on new aircraft and taking on too much debt.
But several analysts are beginning to change their tune on the stock, raising their target prices and arguing that the airline may have reached an inflection point that could result in a significantly higher share price and a valuation closer to its U.S. peers.
“A lot of the things we’ve been doing for the last number of years are coming to fruition and are being appreciated by the market,” Rovinescu said in a recent interview at his Toronto office.
“Relatively speaking, we’re still in the early innings of realizing the full benefit of all the fleet decisions, the configuration decisions and some of the other things that are still to come.”
In the past two months, Air Canada’s stock is up more than 40 per cent, nearing its recent high of $14.50 set in June 2015.
In part, Rovinescu attributes the recent share-price jump to the company’s “super successful” October refinancing, which cut its debt load by $355 million, its annual interest payments by $60 million and its interest rate by 150 basis points.
But it’s more than just a successful financial transaction that’s driving Air Canada’s share price higher. Analysts say the factors that have weighed on the stock in the past are beginning to pay off, making it a much more investor-friendly company.
According to RBC analyst Walter Spracklin, the main factors that kept investors at bay were high capacity, negative yields, elevated capital spending, negative free cash flow and high debt levels.
“Our argument has been that there is a sound strategic basis for these seemingly negative indicators,” Spracklin wrote in a recent analysis. “Regardless, the good news is we believe we are on the cusp of no longer having to defend or explain away these trends, as we are beginning to see (or on the cusp of seeing) inflection points in each of the above.”
Most of the perceived negatives listed by Spracklin are associated with Air Canada’s aggressive international expansion, which has seen its revenue from international routes rise from 54 per cent in 2011 to an estimated 62 per cent in 2018.
One of the biggest drivers of this international growth is so-called sixth-freedom traffic. One of the nine “freedoms of the air” set by the 1944 Chicago Convention on International Civil Aviation, it refers to traffic from one country to another via an airline’s home country. For example, an American traveller who flies Air Canada from Chicago to London via Toronto is a sixth-freedom passenger.
Air Canada’s modest goal is to attract a 1.5-per-cent “fair share” of the U.S. sixth-freedom market, which Rovinescu said would add $600- to $700 million in incremental revenue.
“We think we can do much better than that,” he added. “We’ve been basically increasing our sixth-freedom flying by mid- to high-teen (percentages) in each of the last two years.”
The linchpin in this strategy is Boeing Co.’s 787. Air Canada has ordered 37 of the jets, which have the range of the larger 777 but with fewer seats to fill and better fuel efficiency.
“Some of these (international) routes would just not be capable of being exploited without the 787,” Rovinescu said, citing new direct flights from Toronto and Vancouver to Delhi as an example.
Even with the 787, those routes would not be viable without sixth-freedom traffic, he added.
“We cannot count on filling a Delhi route with only the local Toronto traffic,” he said. “We have to have a lot of U.S. and other Canadian traffic.”
This is one of the fundamental misunderstandings investors have about Air Canada, said Cameron Doerksen, analyst at National Bank.
“Probably the biggest investor pushback we hear on Air Canada is that the airline is adding too much capacity, but we believe investors do not appreciate the fact the airline’s international capacity expansion is not entirely dependent on domestic demand, but rather is well supported by Air Canada’s strategy to grow connecting traffic,” Doerksen wrote in a recent analysis.
He added that Air Canada is “one of the few legacy airlines worldwide that is pursuing an aggressive growth strategy.”
Investors may not have to wait long to see the upshot of that strategy. AltaCorp analyst Chris Murray said he expects the company’s third-quarter results, scheduled to be released on Nov. 7, will “mark an inflection point for valuation.”
“Air Canada’s experiment to grow sixth-freedom traffic levering the Boeing 787 platform and the Toronto hub may have been a different strategy than that of peers, which made it difficult for investors at times to understand and place faith in,” he wrote. “However, we believe this quarter may be the first time that demonstrates clearly how the strategy impacts results.”