When I wrote my analysis on Air Canada back in March, I made clear that I think airlines are terrible businesses. However, the industry landscape differs today from ten to thirty years ago, such that even Warren Buffett, who has historically expressed the industry as unattractive, bought shares in American, Delta, United, and Southwest Airlines in 2017. The airline industry has changed from fiercely competitive to less so, with significant consolidation. Throw in the likelihood of long-term low fuel prices, and it looks as though some of the previous red flags of the past have subsided.
That said, the industry remains dependant on economic prosperity to an extreme. To provide some context, Air Canada reported 95% losses in 2008. While I see some long-term tailwinds for airlines, their general financial fragility tends to make me a little nervous. Not to mention, there is a plethora of factors that can impact airline sales opposed to other commodity companies out side of economic recession. Sure, automakers’ sales take a dive in bad times, but automakers don’t have to worry about terrorism fears, viral outbreaks, storms, and freak accidents like airline operators do. The potentials for sales decline are plentiful and can occur unexpectedly even in the best of times.
In any case, I like cheap companies (who doesn’t?), and I think the high degree of factors that might impact airline sales is actually positive for value investors, as the “might impact” is typically good enough for the herd to flee in terror, offering those patient and disciplined investors with potentially profitable opportunities. If investors are patient, I believe there will be numerous opportunities to purchase airlines at depressed prices in the future, with the comfort that fuel prices are almost sure to remain low in the long-term due to technological improvements that have improved output efficiency and volume. It would take a lot for oil prices to remain at their current elevated prices of $70+, unless there’s a conflict in the Middle East, which is plausible, but unlikely.
The reason why I’ve decided to reflect on purchasing shares in Air Canada is due to the nature in which I valued the company. I chose to value Air Canada using a sum-of-the-parts method of valuation. In my analysis, I compared the estimated liquidation value of several airline’s primary assets to shed light on Air Canada’s significant undervaluation compared to peers.
I employed an unconventional measure to express Air Canada’s cheapness, the fleet to price ratio (F/P). The F/P simply accounts for an airline fleet at a 75% discount, then adds its cash and cash equivalents less its debt obligations. When I valued the company, Air Canada’s F/P ratio of 1.97 was some 120% higher than the industry mean of 0.77, and 80% higher than the next cheapest airline. The picture remains largely unchanged.
Somehow, despite a refinancing of debt to a more attractive rate, strong international growth, and an attractive and improving balance sheet (when considering the state of their cash and pension liability surplus), Air Canada’s F/P ratio remains 50%~ lower than its North American peers. There are two concerns I have regarding the timing and method of my analysis however.
One, we’re arguably in the late part of the current business cycle. Housing affordability in most of the developed world is low, American industry is running at full capacity, interest rates are rising, and labor shortages are stark. Really, this is as good as it gets, and who knows how long the party will continue for.
It is well known that in the later stages of economic cycles is where cyclical companies usually reach their richest valuations, whereby their sales growth begins to slow. It is during this time that cyclicals often appear cheap on a P/E or P/B basis, but are actually expensive. Factoring in investor hesitation due to financial instability, and Air Canada may very well be fully priced.
Two, and most importantly, the market doesn’t have to agree with my value work. While I believe air Canada’s value to be unjustified, and have identified catalysts that I think will help further unlock the company’s value, such as continual cost and efficiency improvements, workplace improvements, and liquidity improvements, general market uncertainty may make investors hesitant to ascribe a just valuation to Air Canada before the next recession (probably due to past financial turmoil).
However, and this is a big however, because there would be significant political and/or public trust implications, central banks could very well initiate another round of quantitative easing (QE) if the impact of increasing interest rates proves more destabilizing than anticipated, which may cause the economy to continue to slug along. Hell, the previous could even be considered a catalyst to unlock Air Canada’s value, insofar as another round of QE would extend the current business cycle, which would give Air Canada’s shares more time to appreciate to a justifiable price, but I wouldn’t bet on it.
To continue, and more to the point, the market doesn’t have to agree with my sum-of-the-parts valuation. The price of airplanes fluctuate wildly depending on flight demand, but I feel I was fair in my 75% discount of fleets to account for the latter. In any case, the instability of airplane prices coupled with nervous investor sentiment might be enough for my thesis not to manifest, despite the attractiveness of my collected data.
I do believe that Air Canada has upside potential in the near-term, but the risk-reward seems less favorable at this point, as the downside could be significant in the case of recession. At this point I’d say there’s a chance of 30% downside or 50% upside over the next twelve to sixteen months, dependent on economic conditions and the direction of fuel prices.
I will continue to hold all my shares for the near-term, but will begin to reduce holdings in Q1 2019 as a precaution. Currently, holdings in Air Canada total 7.5% of my portfolio as my second largest position. Better investment opportunities may be a further justification for a reduction in holdings.
Purchasing share in Air Canada provides a two-fold lesson for me:
- Unless the asset is outrageously cheap in an absolute sense, buying cyclical companies in the mature stages of an economic cycle is likely a poor idea (even though timing an economic turn is a futile activity).
- The sum-of-the-parts method for valuing companies is tricky. Even a particularly enticing case may not be enough for the market to agree. I believe Air Canada as a sum-of-the-parts investment would’ve been highly attractive if the risk-reward was more favorable. My findings were so exciting for me however, that I believe my thesis may have begun as a bit of a self-fulfilling prophecy that ignored a proper assessment of the potential risk-reward.
Nevertheless, I’m not necessarily nervous about the long-term prospects of Air Canada. I believe the company is financially apt to survive the next recession, and business is going well. And, most importantly, I believe Air Canada does remain significantly undervalued relative to peers.
Disclaimer: The information provided in this article expresses my own opinions and should not replace financial advice provided by a certified financial professional. Please seek certified professional advice for all investment-related matters.
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Thoughts on Purchasing Shares in Air Canada
When I wrote my analysis on Air Canada back in March, I made clear that I think airlines are terrible businesses. However, the industry landscape differs today from ten to thirty years ago, such that even Warren Buffett, who has historically expressed the industry as unattractive, bought shares in American, Delta, United, and Southwest Airlines in 2017. The airline industry has changed from fiercely competitive to less so, with significant consolidation. Throw in the likelihood of long-term low fuel prices, and it looks as though some of the previous red flags of the past have subsided.
That said, the industry remains dependant on economic prosperity to an extreme. To provide some context, Air Canada reported 95% losses in 2008. While I see some long-term tailwinds for airlines, their general financial fragility tends to make me a little nervous. Not to mention, there is a plethora of factors that can impact airline sales opposed to other commodity companies out side of economic recession. Sure, automakers’ sales take a dive in bad times, but automakers don’t have to worry about terrorism fears, viral outbreaks, storms, and freak accidents like airline operators do. The potentials for sales decline are plentiful and can occur unexpectedly even in the best of times.
In any case, I like cheap companies (who doesn’t?), and I think the high degree of factors that might impact airline sales is actually positive for value investors, as the “might impact” is typically good enough for the herd to flee in terror, offering those patient and disciplined investors with potentially profitable opportunities. If investors are patient, I believe there will be numerous opportunities to purchase airlines at depressed prices in the future, with the comfort that fuel prices are almost sure to remain low in the long-term due to technological improvements that have improved output efficiency and volume. It would take a lot for oil prices to remain at their current elevated prices of $70+, unless there’s a conflict in the Middle East, which is plausible, but unlikely.
The reason why I’ve decided to reflect on purchasing shares in Air Canada is due to the nature in which I valued the company. I chose to value Air Canada using a sum-of-the-parts method of valuation. In my analysis, I compared the estimated liquidation value of several airline’s primary assets to shed light on Air Canada’s significant undervaluation compared to peers.
I employed an unconventional measure to express Air Canada’s cheapness, the fleet to price ratio (F/P). The F/P simply accounts for an airline fleet at a 75% discount, then adds its cash and cash equivalents less its debt obligations. When I valued the company, Air Canada’s F/P ratio of 1.97 was some 120% higher than the industry mean of 0.77, and 80% higher than the next cheapest airline. The picture remains largely unchanged.
Somehow, despite a refinancing of debt to a more attractive rate, strong international growth, and an attractive and improving balance sheet (when considering the state of their cash and pension liability surplus), Air Canada’s F/P ratio remains 50%~ lower than its North American peers. There are two concerns I have regarding the timing and method of my analysis however.
One, we’re arguably in the late part of the current business cycle. Housing affordability in most of the developed world is low, American industry is running at full capacity, interest rates are rising, and labor shortages are stark. Really, this is as good as it gets, and who knows how long the party will continue for.
It is well known that in the later stages of economic cycles is where cyclical companies usually reach their richest valuations, whereby their sales growth begins to slow. It is during this time that cyclicals often appear cheap on a P/E or P/B basis, but are actually expensive. Factoring in investor hesitation due to financial instability, and Air Canada may very well be fully priced.
Two, and most importantly, the market doesn’t have to agree with my value work. While I believe air Canada’s value to be unjustified, and have identified catalysts that I think will help further unlock the company’s value, such as continual cost and efficiency improvements, workplace improvements, and liquidity improvements, general market uncertainty may make investors hesitant to ascribe a just valuation to Air Canada before the next recession (probably due to past financial turmoil).
However, and this is a big however, because there would be significant political and/or public trust implications, central banks could very well initiate another round of quantitative easing (QE) if the impact of increasing interest rates proves more destabilizing than anticipated, which may cause the economy to continue to slug along. Hell, the previous could even be considered a catalyst to unlock Air Canada’s value, insofar as another round of QE would extend the current business cycle, which would give Air Canada’s shares more time to appreciate to a justifiable price, but I wouldn’t bet on it.
To continue, and more to the point, the market doesn’t have to agree with my sum-of-the-parts valuation. The price of airplanes fluctuate wildly depending on flight demand, but I feel I was fair in my 75% discount of fleets to account for the latter. In any case, the instability of airplane prices coupled with nervous investor sentiment might be enough for my thesis not to manifest, despite the attractiveness of my collected data.
I do believe that Air Canada has upside potential in the near-term, but the risk-reward seems less favorable at this point, as the downside could be significant in the case of recession. At this point I’d say there’s a chance of 30% downside or 50% upside over the next twelve to sixteen months, dependent on economic conditions and the direction of fuel prices.
I will continue to hold all my shares for the near-term, but will begin to reduce holdings in Q1 2019 as a precaution. Currently, holdings in Air Canada total 7.5% of my portfolio as my second largest position. Better investment opportunities may be a further justification for a reduction in holdings.
Purchasing share in Air Canada provides a two-fold lesson for me:
Nevertheless, I’m not necessarily nervous about the long-term prospects of Air Canada. I believe the company is financially apt to survive the next recession, and business is going well. And, most importantly, I believe Air Canada does remain significantly undervalued relative to peers.
Disclaimer: The information provided in this article expresses my own opinions and should not replace financial advice provided by a certified financial professional. Please seek certified professional advice for all investment-related matters.
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Owen Hofmeyr
“Investment is most intelligent when it is most businesslike.” - Benjamin Graham