CA - Air Canada: Long-Term Air Travel Demand Remains The Key Metric

2023-03-22 05:11:22 ET

Summary

• Despite the bad results and guidance in the 4Q22 report, Air Canada is still in a relatively strong position due to its healthy financial situation.
• The long-term growth trends in air travel and the return to travel will serve as the ultimate driver for Air Canada.
• The 10-year labor contract, which will be amendable in early 2024, is something investors should keep in mind.

Summary

In my opinion, Air Canada ( AC:CA ) is still in a relatively strong position due to its healthy financial situation. Despite weak results expected in FY23, I think investors will eventually begin to value AC on a normalized profit basis as the macro economy turns for the better. With profits expected to be back at >CAD4 billion in FY25, the company's balance sheet should improve even more, likely leading to an upgrade in credit-rating, which in turn could allow more funds to hold AC despite mandate restrictions. However, the long-term growth trends in air travel and the return to travel would serve as the ultimate driver for AC. All in all, I am sticking with my buy recommendation and anticipating a return to normalized profitability in FY25.

4Q22 results

The results were bad, and the guidance was also bad. The combination of the two has resulted in a 25% decline in share price since the earnings report, in my opinion. This combination was pretty much consistent with other airlines in the region (albeit AC was worse at guiding). What is worse, I think, is that AC provided a worsened cost outlook for 2024 despite higher growth, lower cash flow assumptions, and a slightly increased leverage target. All that aside, investors should keep in mind that AC is not a US airline, which explains why the recovery of demand has lagged behind that in the US. demand is still higher than the formal forecast made by management last year. This demand trend gives me hope that things will be okay in the long run, even though all the other metrics are pretty bad (affecting the short term). Management could have done better if they had followed the lead of U.S. airlines in how they shared their optimistic FY24 outlook with their investors. I believe investors on the fence have sold off AC stock and adopted a risk-off stance because the company's commentary was significantly less bullish than that of the US airlines. Given that the current macro environment is not 100% favourable for airlines, albeit an underlying recovery momentum from post-covid, any negatives of potential negatives could send the stock in a high volatility mode - as we have seen post the earnings.

AC reported an adjusted EBITDA of $389 million, which was significantly lower than expected. However, recovery momentum is growing, and capacity has recovered to 85% of 2019 levels, up from 79% in the previous quarter. Passenger revenue also increased above pre-covid levels with an increase of 2% vs 4Q19. Transatlantic and international passenger revenues in the 4Q22 have also surpassed pre-covid levels with management expecting continued robust outlook. As for full year CASM-ex, management attributed the slightly higher-than-anticipated CASM-ex to various factors, including inflationary, costs associated with customer disruptions, and high passenger traffic. Adjusted EBITDA margin for the full year came in at 8.8%, below the 8-11% it had forecast for 2022 due to rising costs of energy and consumer prices. Elsewhere which was a highlight is that despite a marginal increase in capacity, AC's cost projections have deteriorated by about six percentage points.

Demand trend

As I said, what matters in the long-term is air travel continue to grow, and that is what management is seeing as well. AC now sees capacity restored to 100% of 2019 levels in 2024, which is a step up from the 95% previously provided in last year Investor Day. Note that this suggest increasing momentum in recovery, but of course, relative to the US airlines, AC is still lagging. This might have put AC in a lesser favorable position from a like-for-like comparison, but I argue that this also means AC has higher growth momentum in the short-term as the growth burst from travel recovery has not fully reflected in AC financials yet.

10-year labour contract

In case any investors have forgotten, the 10-year labour contract will be amendable in early 2024. Unfortunately, again a communication problem, management did not give a clear response to whether its worsened cost outlook included the impacts of this renewal. On the one hand, this isn't that out of the ordinary; the contract cycle is winding down, so it's best not to spill the beans until everything is set in stone. However, I don't see any reason why AC can't do what American Airlines and other US airlines did: publish guides that take into account the effect of contract renewal. I believe a lot of investors just as I are disappointed with management lack of more transparency, which would have been beneficial to the stock's sentiment. Given that most contracts are for four years, I also wonder if the next deal will be a 10-year deal. Having this information is helpful because it makes estimating and understanding labor costs for the next decade much simpler in the context of a 10-year contract. Investors in AC would be aware that labor costs are typically the second-highest for airlines (after fuel). Another reason why I would prefer a 10 year deal is also because of the hot demand for pilots which would push up cost even further. In any case, it does not make sense for management not to include the impacts from this renewal in the guidance anyway as it would set itself up for potentially-material cost miss. Then again, communication is not management forte, so we will see.

Conclusion

While AC 4Q22 results were disappointing and its guidance was not as optimistic as that of US airlines, I believe the company's healthy financial situation and expected return to normalized profitability in FY25 will eventually lead investors to value the company on a normalized profit basis. Most importantly, the long-term growth trends in air travel and the return to travel will be the ultimate driver for AC. Despite the timing of the upcoming 10-year labor contract renewal, I still believe that AC's management can do better in terms of communication with investors - which I hope they do moving forward. Overall, I am sticking with my buy recommendation for AC, and I am anticipating a return to normalized profitability in FY25.

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