Airline stocks to see slow ascent

Airlines also are affected by the price of oil, given their large fuel requirements, and by changes in the value of the Canadian dollar, which affects consumer demand for foreign travel.

But, in the past year, Air Canada and WestJet have “really curtailed” expansion, keeping increases in capacity to 2%-3% while demand has risen by 6%, says Joe D’Angelo, portfolio manager with Signature Global Advisors, a division of CI Financial Corp. in Toronto.

Despite still posting losses, D’Angelo says, Air Canada is currently in the best position it has been in for some time, mainly thanks to the federal government’s assistance in reaching labour agreements that will lower pension costs and provide the flexibility to start a low-cost carrier (LCC) subsidiary airline and remain competitive asWestJet enters the regional market business. In addition, Air Canada’s heavy maintenance costs are expected to drop significantly, as it is in the process of negotiating with new suppliers.

WestJet, which doesn’t have a unionized workforce or the pension costs of an older airline such as Air Canada, is in very good shape and is pursuing growth opportunities that include not only penetrating the regional market but also offering premium service aimed at the business traveller.

However, if the economy hits a soft patch, demand will go down, taking the stock prices with it, D’Angelo cautions. The funds he manages don’t hold stock in either company because of that risk, but he believes that both companies have growth opportunities that could pay off.

Recent reports from Toronto-based Canaccord Genuity Corp. and TD Securities Inc. are more enthusiastic, as both reports have a “buy” rating on the stock of both airline companies – although the report from TD labels its recommendation on Air Canada as a “speculative buy,” which denotes great opportunity but also a lot of risk. That is, the stock’s total return is expected to exceed 30% over the next 12 months but there is risk that the investment could result in significant losses.

WestJet has increased its quarterly dividend twice this year. That dividend now is 8¢ a share, for a dividend yield of 2%. Air Canada doesn’t pay a dividend.

Here’s a closer look at the two companies:

AIR CANADA has daunting ongoing challenges, given the high costs associated with its unionized workforce. The airline also will have to cope with WestJet’s pending move into the regional market. That said, recent labour agreements have provided some breathing room and will make it easier to establish Air Canada’s planned LCC airline.

The labour agreements, reached with all Air Canada’s unions over the past 18 months, will reduce the company’s pension deficit to $3.3 billion from $4.4 billion. Unions are expected to support the company’s efforts to receive an additional 10 years of pension funding relief from the federal government. Contracts have been revised to pay lower salaries for those working on the LCC airline. Previous restrictions on the company’s ability to add to its regional aircraft fleet also have been eased.

Another cost-saving move is the cancellation of heavy maintenance contracts with Montreal-based Aveos Fleet Performance 5I2nc. As the Canaccord Genuity re0p2ort says: “It appears Aveos’ costs were well above market rates.” Air 5C1anada is in the process of negotiating with other suppliers.

In addition, the Canaccord 01 Genuity report points out that Air 5Canada’s pension deficit will improve when interest rates normal0ize. The current, very low interest rates push up the deficit because projected pension liabilities have to be calculated assuming that the current level of interest rates persists indefinitely. Rate normalization won’t happen soon, but eventually the U. S. and Europe will get back to normal growth and interest rates will rise to reflect that.

Air Canada has tried twice to establish an LCC airline. ZIP, operating in Western Canada, had been established in 2002 and disbanded in 2004. Air Canada Tango, flying between Toronto and major Canadian cities and three Florida destinations, had started in 2001 and was dissolved in 2004.

The new LCC is expected to start sometime in 2013 and fly to Las Vegas, Florida, the Caribbean and across the Atlantic – all routes on which the main airline has trouble competing.

WestJet’s entry into the regional market is a potential threat. Air Canada’s bread and butter is business and long-distance travel; in the latter case, D’Angelo explains, Air Canada has to have a strong regional network to get the travellers to the hubs from which the long-distance flights originate. If travellers take WestJet to a hub, they may not take Air Canada to their final destination.

Air Canada lost $490 million on revenue of $11.9 billion in the 12 months ended June 30, vs earnings of $341 million on revenue of $11.3 billion for the corresponding period a year earlier. This year’s loss is due mainly to the negative impact of changes in foreign-exchange movements vs gains the year prior, but there also had been lower operating income, partly due to work stoppages related to union negotiations.

The company’s 278.4 million outstanding shares closed at $1.07 on Sept. 7. The Canaccord Genuity report, which assumes “moderate sales and margin increases,” has a 12-month target price of $5 a share but warns that “excess competition” to the U.S. northeast, Europe (particularly Britain) and “sun” destinations could continue.

The TD report says, “Greater clarity from the company on future fleet changes, pension relief and cost-structure guidance will be required to generate a meaningful and sustained rally for the stock price.” This is expected within the next two quarters _ hence the “speculative buy” recommendation and target of $2.50 a share.

westjet airlines ltd. would be the airline stock that D’Angelo would choose to hold if he were to buy one of these stocks, saying, “It’s firing on all cylinders.”

He likes the fact that WestJet’s management doesn’t just sit around but experiments. In particular, D’Angelo says, WestJet’s new CEO, Gregg Saretsky, who started in 2010, is doing an “outstanding” job. The problem, D’Angelo says, is a lot of good news is already priced into the stock and, if the economy slows, the airline’s volumes will suffer.

The company’s plans to go into the regional market is logical, says D’Angelo, adding, “And if it doesn’t hit a soft patch in the economy, that should drive further growth in earnings per share [EPS].” He notes that WestJet is purchasing the same airplanes that the small, private Toronto-based Porter Airlines Inc. operates.

WestJet also is reconfiguring its larger planes to provide some premium seating. This doesn’t mean a loss of seats, as the airline is reducing the seat pitch _ the angle of the seats _ of the rest of the seats slightly. Indeed, on some planes, the total number of seats will increase by 1%.

Aimed at business travellers, passengers in these premium seats will have more legroom, priority boarding and other amenities. The TD report says the “value proposition of a full-fare business cabin” will be attractive.

This strategy reflects the wall that WestJet has come up against, D’Angelo explains. The company can’t drop its general fares any further, so the airline needs to find other ways to grow. Blending in some features of traditional airlines is an obvious way to go.

The question is whether the change in seat pitch for the remaining seats will have a negative impact on demand from WestJet’s traditional passengers. The TD and Canaccord Genuity analysts don’t think it will. In particular, the TD report says, analysts don’t believe it “will even be noticeable by the majority of travellers, let alone lead to a competitive disadvantage.”

The Canaccord report points out that WestJet says that the new seat angle “is consistent with the rest of the industry.”

WestJet’s net income was $185.7 million on revenue of $3.3 billion in the 12 months ended June 30, vs $154.8 million on revenue of $2.9 billion for the corresponding period a year earlier.

The 134.1 million outstanding shares closed at $17.45 on Sept. 7. The Canaccord Genuity analysts have a 12-month target price of $25 while the TD analysts have a target of $24.

The Canaccord report says WestJet is “on track for solid, double-digit EPS growth for at least the next two years from moderate sales growth and free cash benefits.” The report projects “strong, stable margins, which

should enable the company to fund its fleet growth and have cash left over for further share buybacks and dividend increases.”

In addition, the Canaccord Genuity report says the downside risk for the shares “may be limited, as the stock is still very inexpensive.” That report points out that WestJet’s current EV/EBITDAR _ enterprise value (market capitalization plus debt, minority interest and preferred shares, minus cash and equivalents)/earnings before interest, taxes, depreciation, amortization and restructuring or rent _ is around 3.6%, vs Canaccord Genuity’s 4.5% 2012 estimate for the airline industry overall.

EV/EBITDAR is a commonly used metric for airlines because it includes aircraft rent and ownership costs, which can vary significantly among airlines due to differences in the way the companies finance their aircraft and asset acquisitions.

The TD analysts also don’t think the shares’ discounted valuation is warranted. As the TD report says, the company “continues to benefit from domestic capacity discipline, new airline partnerships and growth in corporate penetration.”

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