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Morningstar's Take AC
Air Canada Is Shifting to Growth Mode, Adding Capacity
and Bringing its Loyalty Program In-House. Price 11-12-2018 Fair Value Uncertainty
Estimate
26.70 35.00 Very High
Analyst Note 11/12/18
Consider Buy Consider Sell Economic Moat
We maintain our fair value estimates of CAD 20 for Westjet and CAD 35 for Air Canada after reviewing our outlook.
17.50 61.25 None
Likewise, we maintain our no-moat ratings and stable moat trends. Air Canada shares trade at a material discount to our
fair value estimate, but Westjet shares appear fairly valued.
Stewardship Rating
Standard
These operate as a duopoly in an air travel market characterized by expensive government fees and taxes that get
passed on to travelers, reliance on U.S. transborder travel, and a limited market size. Because this environment isn’t
conducive to material economic profits, Air Canada has worked to improve returns through cost transformation that
Bulls Say
included optimizing routes and retooling its fleet. Realizing the limitations of the Canadian market, the firm also
embarked on global expansion strategies, ordering widebody aircraft and capitalizing on sixth freedom traffic (flying U.S. • Air Canada's introduction of the 737 MAX and 787 aircraft will drive
passengers internationally from Canadian airports). Air Canada also plans to revitalize its loyalty program. Initially, the unit costs lower, thanks to better fuel efficiency and up-gauging,
carrier planned to launch a new rewards program in 2020, but its announced acquisition of Aeroplan will jump-start this helping to increase margins.
process, adding 5 million members and generating CAD 1.4 billion in added value. Acquiring Aeroplan allows Air Canada • The company's low-cost arm, Rouge, will compete effectively against
to capitalize on highly favorable loyalty program economics, with operating margins approximating 60%. other low-cost carriers like Wow Air and Westjet's new ultra low cost
carrier arm.
Westjet on the other hand, found success in the Canadian domestic markets for years, capitalizing on the low-cost • Canada's economic growth will accelerate in 2018, and Air Canada's
carrier model, but rising fuel prices and union complications changed this narrative. Now, Westjet plans to improve hubs will see an increase in air traffic.
returns by turning away from its low-budget origins, catering to more affluent travelers, and incorporating transatlantic
and transpacific routes on its network. While we assume revenue growth will remain robust through Westjet’s
aggressive capacity expansion, we don’t model strong gains in pricing, and project margins will fail to reach record levels Bears Say

of the past five years. • Air Canada's refleeting will cost about CAD 6 billion over the next
several years, placing upward pressure on capital expenditures and
depressing cash flow.

Thesis 11/12/18 • Air Canada's international expansion will not succeed due to strong
competition from non-Canadian carriers and Westjet; this will result
in unprofitable routes to the carrier's network.

• Ultra-low-cost carriers will enter the Canadian market and create fare
Valuation
pressure across the industry.

Our CAD 35 fair value reflects the inception of Rouge, Air Canada’s Aeroplan program, and an outward focus toward
globalization. Acquiring Aeroplan allows Air Canada to capitalize on highly favorable loyalty program economics. We
suspect airline loyalty programs traditionally register operating margins around 60% in North America.

We model expanding international capacity through sixth freedom (flying U.S. passengers internationally from Canadian
airports) flying and by flying travelers from the U.S. to international locations. We also assume the average annual
growth rate for domestic travel will decelerate and fall below international average annual growth rates as most
Canadian markets have reached maturity. We project an average annual growth rate of 2% for Air Canada’s domestic
network. Moreover, our model includes load factors declining marginally, as Air Canada, in tandem with other North
American carriers, continue adding capacity to a slowing global air travel market.

Yields are flat through our 2022 midcycle period but yields grow over 1% on average through 2019, as Air Canada
recoups rising fuel costs and takes advantage of increased cabin segmentation and upgauging. Conversely, we expect
carriers to bid down yields as oil prices retreat to our $60 Brent midcycle price. In this scenario, Air Canada’s yields
decline almost 1% between 2020 and 2022.

Consolidated revenue growth averages 6% over the next five years in our model against the backdrop of robust revenue
growth from other revenues. We expect the continued roll-out of new fare categories and unbundling to buttress 8%
revenue growth in the first half of our forecast. Our model includes operating margins averaging 7.9% through 2022,
starting in 2018, slightly below the prior preceding five-year period that saw operating margins average 8.1% and peak
at 10.8%. Margins peak at 9.1% in our stage I period, but we anticipate Air Canada will benefit from costs per available
seat mile, or CASM, remaining flat thanks to falling oil prices countering rising employee costs. We assume, employee
wages and benefits drive manageable costs excluding package costs and fuel growth at 1% per year. We believe wages
and benefits will rise 2% year over year under Air Canada’s 10-year union agreement signed in 2014.

Risk

Air Canada faces demand risks from economic and political shocks. There have been four major air travel disruptions
since the late 1970s: the second oil shock (1979), the first Gulf War (1990), the dot-com bust (2001), and the financial
crisis (2008). Other localized events have occurred, such as SARS in Asia during 2003. Air traffic typically returns to
trend level four years after an event. Nonetheless, high fixed costs and inflexible near-term capacity mean disruptions
can quickly destroy profits.

Air Canada reports in Canadian dollars, but much of its debt and expenses is U.S.-dollar-denominated. Although a
depreciating Canadian dollar boosts revenue on international routes, it also increases U.S.-dollar-denominated operating
expenses. The company tries to cover 70% of its net U.S.-dollar-denominated cash flow exposure by holding U.S.-dollar-
denominated cash as an economic hedge, while employing derivatives.

Despite the drop in oil prices, fuel expense still accounts for about 20% of total expenses. Air Canada hedges fuel
through out-of-the money calls that protect against significant price increases, while enabling it to participate in

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decreasing fuel prices. The cost of these calls stood at about CAD 30 million in 2017. That said, it has slowed down its
hedging program as of late and at the end of the first quarter 2018, the carrier wasn't hedged for any of its anticipated
2018 fuel consumption. Historically, the value of the Canadian dollar is positively correlated with oil prices, providing the
company with a natural hedge against rising fuel prices. However, this relationship may break down with rising U.S.
interest rates.

Similar to other airlines, labor remains a significant expense, and salaries and related expenses account for around 20%
of Air Canada's operating expenses. However, both the pilots and flight attendants are under 10-year contracts that last
until the mid-2020s, providing long-term visibility into labor costs.

Management & Stewardship

We assign Air Canada a Standard stewardship rating. We commend current CEO Calin Rovinsecu and his team for
transforming the airline. Since assuming the CEO role in 2009, he’s handled labor disputes, record fuel prices, sizable
pension deficits, and a balance sheet that was formerly leveraged to the hilt. After guiding the company through each of
the aforementioned problems, the carrier finally turned a profit and set its sights on expanding globally and delivering
additional cost transformation.

Management’s focus now turns to enhancing its globalization efforts and ramping up capacity through Rouge. Aircraft
re-fleeting currently takes priority over share buybacks, and we also think management would like to pay down debt
further as it targets a debt/EBITDA leverage ratio of 1.2 times in 2020; however, we do model share repurchases over
the immediate future.

Lastly, Air Canada maintains two share classes because the Canadian government sets foreign ownership restrictions on
Canadian airlines for national security purposes and to maintain travel market competitiveness.

Overview

Financial Health:

Air Canada’s financial health is markedly improved over the years immediately following 2008 and 2009, giving credence
to the transformation CEO Revinescu and his team implemented. As of year-end 2017, Air Canada total debt/capital fell
set new marks below 60% and well below the 100% posted between 2010 and 2014. Air Canada’s leverage is now
manageable, and the company is well on its way to eclipsing the adjusted net debt/EBITDAR level of 2.2 times by the
end of 2018, compared with net debt/EBITDAR ratios of less than 2.0 times for the most financially sound airlines.
Management contends its main focus is pairing down debt, and we think this is achievable with CAD 2.5 billion in
operating cash flow and capital spend falling to CAD 2 billion starting in 2020. We model total debt/EBITDA falling to 1.5
times in our 2020 midcycle year as management looks to pay down debt and achieve an investment-grade rating.

Profile:

Air Canada is Canada's largest airline, serving nearly 50 million passengers each year together with its regional partners.
Air Canada provides over 1,500 daily flights to around 200 destinations and is a founding member of the Star Alliance. In
2017, the company generated CAD 16.3 billion in total revenue and posted 8.4% operating margins.

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