Air Canada’s share price is down nearly 20% from the closing high of $27.92 reached in October 2017. Tim James, Research Analyst, TD Securities, talks to Sara D’Elia about the recent weakness in the share price and explains whether investors should use this as an opportunity to buy, sell or hold Air Canada shares.
Over the last 12 months, Air Canada shares have been turbulent to say the least. They spiked nearly 130% and then started to come back down as higher fuel costs, new discount players, and even air traffic had investors worried. But my guest says he's buckling up and keeping his buy recommendation. Joining us to explain is Tim James from TD Securities. Thanks for being here.
Did you enjoy all my airline puns? I almost debated pointing out the exits for you, and then I thought I should just quit while I'm ahead. So you're here to talk about Air Canada. But before we get started with you, I want to bring up a clip from a guest we had on the show talking about the travel industry a couple of months ago.
People were happy before buying goods, whether it was new flat screen TVs, new furnishings for their house, bigger houses, new cars. Whereas the current boomer generation would rather spend their money on vacations and take pictures of those vacations and post to Instagram. It's a completely different segment of the population that has different needs. And companies that are tied to fulfilling those needs will outperform, as you can see from the chart.
Now, Tim, you and your team have had a buy rating on Air Canada for a little over two years. Are you attracted to this name because of some of the characteristics Damien mentioned, so those demographic shifts? Or is it something unique about this stock?
Well, certainly over the very long term, the demographic trends that we see in Canada-- and that's an increased propensity to spend disposable income on travel-- is very good for the airline industry and Air Canada in particular. Our actionless buy rating on the stock is more predicated on the next 12 months, and there's a couple of reasons for that.
First of all, and most importantly, is the stock remains very inexpensive. It trades at around seven times our estimated earnings forecasts for 2018 and less than five times when we look at 2019. And that compares to other Canadian industrials, which would be in the mid to high teens. So it's very, very inexpensive. We compare that to US airlines. There's an equally attractive valuation comparison.
The second point I would make is that it has an excellent financial track record. Now, a lot of people don't realize this, but Air Canada, really going back to 2009, has been generating excellent financial results, improving its balance sheet, generating growing earnings every year.
And the third point I would make, also a little bit different here, is that the stock is still misunderstood in the market. There is a lot of investors out there in Canada that haven't done their work on it and don't really understand the value that exists in an airline. They've taken a look at the last several decades, looked at these airlines coming in and out of bankruptcy protection, and decided they just don't want to do the work on Air Canada or airlines in Canada. And that, I think, creates an opportunity as everybody moves forward and actually does the work and understands the value.
With the recent price decline, we're about 15% to 20% off the highs. What do you think is driving that decline? Has there been a fundamental shift at Air Canada?
Well, there's two primary reasons I would point to. Number one is the increasing price of oil or jet fuel over the last several months. Obviously, higher jet fuel costs pressure earnings in the short term for the airlines. Secondly, there's been a number of investors that have done extremely well in Air Canada over the last couple of years. And their positions in it have risen to such great heights relative to the rest of their portfolio that they've had to prudently take some profits and reduce their exposure.
I think there's been other sellers in the market that have gotten on as those investors have taken profits here. The important thing is the fundamental story-- the long-term fundamental story really hasn't changed with Air Canada. Even when we think about the slightly higher jet fuel prices that we're experiencing now, demand for air travel has also increased, and that really offsets some of that pressure, we believe, from the slightly higher jet fuel prices.
As I mentioned earlier, you are keeping your buy recommendation, and you've assigned a $34 price target. What makes Air Canada attractive right now?
Well, one important thing to keep in mind is that 12 months ago-- even though the stock has done extremely well over the last 12 months-- 12 months ago it was extremely undervalued and really misunderstood by the market. It's starting to get more widely followed and reflect the fair value. But there's still a lot of upside, in our view, to the mid-30s over the next 12 months.
Even if the stock continues to trade at the same valuation multiples that it is today in 12 months from now, that gets you to the mid-30s. If there is expansion in the multiples and the market looks more favorably on it, recognizes the improving balance sheet, the potential for an investment grade credit rating, a dividend, you could see a stock beyond 12 months that's significantly higher than the mid-30s, in my view.
Something else you talk about in your report is Air Canada's position relative to some of their competitors in the US. Tell us a little bit about what you're seeing there.
Well, there's three primary reasons I would cite there. Number one is there's much more growth opportunity for airlines in Canada. Over the last decade or so, airlines in Canada have really under-invested in international capacity growth, and that's something Air Canada is taking advantage of today and which US airlines just don't have that same opportunity.
Second point I would make is that there's a much greater competitive environment or more challenging competitive environment in the US market. There are four majors and a number of low cost airlines in the US which make the competitive environment and the pricing environment much more challenging. In Canada, we've primarily got Air Canada and WestJet today, and that creates a healthier pricing environment, which is good for earnings, and I think makes me look more favorably on Air Canada relative to US airlines.
The third point I would make is the positive relationship between the price of oil or jet fuel and the Canadian dollar. When the price of oil or jet fuel goes higher, over the long term, the Canadian dollar tends to go with it. And that acts as an offset for Air Canada's earnings.
Now, something I want to highlight, and this is probably an overshare, is people might see your report with a buy recommendation and think, this is it. I'm doing it. But you do highlight a number of risks-- things like competition, the Canadian dollar, fuel costs. You even talk about pension funding. So what are the key pieces that you're watching right now that could potentially change the game?
Well, two key risks I think that investors need to be aware of right now. One is the competitive environment. There are two things happening in the competitive environment.
Number one, there are three entities in Canada that are trying to start up ultra-low cost carriers. These are airlines that have very low cost structures and put very inexpensive fares into the market, and that obviously can create pressure in pricing for Air Canada at the low end of the price curve where more cost-conscious travelers operate. We think it's going to take many years for that to have any material impact on Air Canada, but it's something that's important to watch.
The second component of the competitive environment risk is WestJet's plans to move into the international market with new Boeing 787 aircraft. Beginning in 2019, they're planning on acquiring approximately three aircraft per year, up to a total of perhaps 20 aircraft over a number of years. Keep in mind, Air Canada has a fleet of 75 wide-body aircraft, and that's the aircraft that these WestJet planes are really going to be competing with. So we also think it's going to be a long time before that really has an impact on Air Canada.
The third risk I would really point out is, of course, a recession in Canada. Inevitably that's going to have an impact on the earnings and the cash flow of Air Canada. We think the company is far better positioned to deal with a recession in Canada than it ever has been historically, given its strong balance sheet, its cash position.
We don't think you're going to see the days of old where Canada goes into bankruptcy protection every time there's a tough economic environment. The company is very well prepared and insulated against such an event. And we think it will just create some pressure on the earnings but not totally change the long-term story and the long-term value in Air Canada.
Tim, you've given us a lot to think about from potential risks as a recession, routes, and even low cost players. Thanks very much for being here.
Thank you very much.